Where Do Alphas Come From?: A New Measure of the Value of Active Investment Management

The value of active investment management is traditionally measured by alpha, beta, track-ing error, and the Sharpe and information ratios. These are essentially static characteristics of the marginal distributions of returns at a single point in time, and do not incorporate dynamic aspects of a manager's investment process. In this paper, I propose a new mea-sure of the value of active investment management that captures both static and dynamic contributions of a portfolio manager's decisions. The measure is based on a decomposition of a portfolio's expected return into two distinct components: a static weighted-average of the individual securities ' expected returns, and the sum of covariances between returns and portfolio weights. The former component measures the portion of the manager's expected return due to static investments in the underlying securities, while the latter component cap-tures the forecast power implicit in the manager's dynamic investment choices. This measure can be computed for long-only investments, long/short portfolios, and asset allocation rules, and is particularly relevant for hedge-fund strategies where both components are signicant contributors to their expected returns, but only one should garner the high fees that hedg