Devoted to understanding the basics and fundamentals of investing

According to Clarke, de Silva and Thorley in their article,  “Portfolio Constraints and the Fundamental Law of Active Management,” Financial Analysts Journal Vol.58, No.5 September/October 2002, pages 48-66, the constraints placed on portfolio managers affects the amount of the theoretical information ratio the manager can deliver to the client.  In other words, the more limits you place on me the less of my expertise can I turn into returns for you.

The biggest limit is the long only constraint.  This says I can buy a stock and I can sell a stock that I own, but I can't sell short.  Having this single constraint means the manager can only deliver 60% of the information ratio possible. 

The article set off a fire storm in the industry.  It suggested that you didn't need to be able to short the entire value of the portfolio to get most of the information ratio.  They looked at a 120/20% portfolio.

Scott Patterson of The Wall Street Journal noticed the proliferation of 130/30 funds and wrote an article in the October 13, 2006 issue on page C1.  He referenced the Clarke, et.al. article but missed the point in my opinion.

In a 130/30 fund you start with 100% of your principal.  You invest it in the stocks you like the best.  The fund manager also has a list of the stocks she really hates.  You sell enough of these short to raise 30% of the value of your portfolio (the 30% in the name).  You use these funds to buy 30% more of the stocks you like giving you 130% of the original (the 130% of the fund type).  This ratio allows you to deliver essentially all of the information ratio to your client.  The client still gets substantial protection from the perils of short-selling leverage.  The manager gets to deliver superior returns to a long only strategy.

Patterson rightly points out that this strategy is more risky.  Extra return always entails extra risk.  But over time the better transfer of the information ratio to the client should pay for the risk.  That is one of the major points I think Patterson misses.

In other news, my publishers KnowMoreMedia have disclosed their new pay package.  It is more aligned with the revenue they are generating from their stable of authors and tries to be more than fair.  I have proposed that they let me use the material I have written on this site to write a book.  We would repost better organized better written articles when I was finished.  Hopefully the book would drive enough traffic to the site to make the new compensation package worth while.  I would then resume posting to the site.  They would leave the site up and I would continue to respond to comments. 

If they accept my proposal I will be off line for six months or so.  If they don't, this is goodbye and thank you for enriching my life with your comments.  I will miss the association.