35. The Fundamental Law of Active Management: Part 2

Insights from Jonathan Larkin

Now we see that it we want to increase IR, we need to increase either or both of IC and B. But what are these two mysterious terms? IC is skill and B is breadth. IC is the information coefficient as we learned above. It makes perfect sense that if you have better skill at making predictions, then you will have a better strategy and higher Sharpe Ratio right?

When first coming to quant finance, people typically stop there. They spend all their time trying to increase the quality of a narrow set of forecasts. Of course this is important, but I’ll let you in on something well known in the industry, but not so when known outside: the IC for even the best quants in the world is relatively not very high. In fact, you might be surprised to learn that the count of profitable trades as a ratio to all trades (a measure similar in spirit to IC) by the best, well-known quants is typically just a bit higher than 50%. And if that’s surprising, I’ll tell you something else which might shock you: in general, great discretionary investors have the advantage over great quants when it comes to IC. Quants however, have an advantage when it comes to breadth.