The Fundamental Law of Active Management, developed by Richard Grinold and Ronald Kahn, provides a decomposition of the key drivers of active portfolio performance:
IR ≈ IC × TC × √N
where:
- IR — Information Ratio: the consistency of active outperformance relative to a benchmark
- IC — Information Coefficient: the skill of each individual forecast
- TC — Transfer Coefficient: how fully the signal is expressed in the portfolio after constraints
- N — Breadth: the number of independent bets made per year
Strategic implications
The square root on N means breadth has diminishing returns: doubling the number of bets improves IR by √2 ≈ 1.41×, not 2×. Improving IC or TC scales IR directly with no diminishing returns. A manager with modest IC but very high breadth (many assets, many signals) can achieve the same IR as one with exceptional IC in a concentrated portfolio. The law argues for diversification of both assets and signals.