Timing versus Sizing Skill in the Investment Process

Ronald J.M. Van Loon

JPM 2018, 44 (3) 25-32

doi: https://doi.org/10.3905/jpm.2018.44.3.025
http://jpm.iijournals.com/content/44/3/25
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 Timing versus Sizing Skill
in the Investment Process
Ronald J.M. Van Loon

Ronald J.M.
Van L oon
is a portfolio manager
at BlackRock in London,
U.K.
ronald.vanloon@blackrock.com
T
he information ratio (IR) is one
of the key performance metrics
in active portfolio management.
It is defined as the ratio of active
returns of a portfolio or strategy to the stan-
dard deviation of those active returns. It can
be used to compare added value between
portfolio managers or between investment
strategies and measures how effective the port-
folio manager has been in transforming active
risk into active return. Active risk originates
from active management, with the portfolio
manager choosing to overweight or under-
weight securities relative to a benchmark and
choosing the size with which to do so.
The IR measures the outcome of the
active management process, but it does not say
anything about the process through which the
outcome was established. Was excess return
created because the portfolio manager chose
the right overweights and underweights,
or was it due to position sizing—allocating
larger exposures to the investment decisions
that proved correct versus the decisions that
proved incorrect? These are questions of skill,
with the former being an example of the
portfolio manager having skill in direction
timing and the latter being an example of
the portfolio manager having skill in posi-
tion sizing. Both types of skill inf luence the
IR, but in different ways. In this article, we
investigate the relationship between the two
types of skill and the IR.
The relationship between skill and the
IR has been formalized in the fundamental
law of active management (Grinold [1989]),
which relates the maximum attainable IR
to the information coefficient (IC, defined
as the correlation between the manager’s
forecasts and subsequent realized return) and
to breadth (N, the number of independent
positions per year) in the following form:
IR ≈ IC N (1)
The fundamental law offers an important
insight, which is that for investment success,
“it is important to play often (high breadth)
and to play well (high IC)” (Grinold and
Kahn [2000, p. 157]), but it is not intended
as an operational tool. For an effective prac-
tical implementation, there are operational
challenges in both the measurement of IC
as the measurement of N. The IC is the full
sample correlation between the manager’s
forecast and the subsequent realization of
those returns. It thus depends on the manager
explicitly forecasting the expected return
of every decision over its given investment
horizon and setting the size of every posi-
tion in accordance with the law, which is not
what every manager does. For fundamental
or judgmental active investment processes in
particular, the manager will typically forecast
the direction of the position (e.g., outperform
or underperform) but will decide on the size

Winter 2018 The Journal of Portfolio M anagement    25

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independently, depending on conviction, liquidity, and
other factors. This makes the IC difficult to interpret
for a fundamental or judgmental investor.
The fundamental law has been extended in a
number of ways to deal with the operational challenges.
Clarke, de Silva, and Thorley [2002] considered the
impact of investment constraints and showed that the
maximum obtainable IR is reduced in the presence of
constraints. Hallerbach [2014] applied the fundamental
law to directional forecasts only, that is, where only
the direction of the forecast is used for positioning but
where the size of the position is independent of the size
of the forecast. Different assumptions on the distribu-
tion of excess returns are considered. For a directional
timing strategy in which excess returns follow a normal
distribution, they showed that IR must be reduced by a
2
scaling factor of approximately , or 20%.1
π where
Constable and Armitage [2006] offered an alterna-
tive interpretation of the link between skill and the IR
by defining skill as the batting average, or the proportion
of investment decisions that the portfolio manager makes
that prove correct. Modeling the active management
process as a binomial process, they formalized the rela-
tionship between the IR and the batting average, p, for
a single decision over a single period (N = 1) as
2p − 1
IR =
2 p(1 − p )
Notably, both approaches express skill through
a single metric, either the IC or the batting average,
without making the distinction of whether skill origi-
nates in accurately forecasting the direction of the return
or accurately forecasting the magnitude of the return.
Constable and Armitage [2006] considered examples
of when the return distribution is skewed and showed
that, when two strategies have the same IR, the batting
average will give independent and additional informa-
tion about the skewness of the return distribution.
In this article, we extend the binomial process by
introducing skewness in the return-generating process.
This will allow us to disentangle skill in forecasting
the direction of the return from skill in forecasting
the size of the return. We start with a single-strategy,
single-period example before extending to more realistic
settings.
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THE RETURN-GENERATING PROCESS
Consider an investor with starting wealth S 0.
At the start of the period, the investor makes either an
overweight (long) or underweight (short) investment
decision in an investment strategy. At the end of the
period, either the decision proves profitable (generating
a positive rate of return of u with probability p) or it
proves loss making (generating a negative rate of return
d with probability 1 - p). The return-generating process
can schematically be represented as in Exhibit 1.
The single-period expected return on that strategy,
E(r), can be represented as
 uS   dS 
E(r ) = p ln  0  + (1 − p )ln  0  (3)
 S0   S0 
p = probability of a win
ln(x) = the natural logarithm of x
u = the positive rate of return in case of a win
d = the negative rate of return in case of a loss
S 0 = the original investment
Now consider the case in which ln(u) = -x × ln(d).
This represents the situation in which the return in case of
a win is a fixed proportion of the return in case of a loss.
(2)
If x = 1, the return-generating process is symmetrical and
will be determined by ln(u) and p. The process will then be
a special case, as described by Cox, Ross, and Rubinstein
[1979]. If x ≠ 1, the return-generating process is no longer
symmetrical, and the return in case of a win will not equal
the return in case of a loss. We take an ex-post view of
investment skill. If the investor has skill in market timing,
the investor is more likely to call the direction of the return
correctly, and p > 0.5. If the investor has skill in position
sizing, winning positions will return more than the nega-
tive return of losing positions, and x > 1. We can rewrite
the single-period expected return of the strategy as
1 1
E(r ) = ln(u )  p − + p  (4)
 x x 
The variance of the strategy can be written as
 1 2
Var (r ) = ln(u )2  p(1 − p )  1 +   (5)
  x 
Exhibit 1
The Return-Generating Process
The expected IR of the strategy is the ratio of
the expected return of the strategy over its standard
deviation, σ(r), or the square root of variance. Note that
this ratio is time dependent because the denominator and
nominator scale differently with time. For the single-
period, single-strategy case, when we set the period Δt
as one year for simplicity’s sake, we can express the IR
in annualized form as
1 1
p 1+  −
E( r )  x  x (6)
IR = = normal. Returns will be close to the center of the distri-
σ(r ) 1
p(1 − p ) 1 + 
 bution when p ≈ 0.5 and x ≈ 1. Similar to the results of
 x
Note that in the symmetrical case of x  =  1,
Equation (6) collapses into our Equation (2), the defi-
nition of IR over a single period as by Constable and
Armitage [2006].
In practice, the value of p will be close to 0.5,
hence p(1 − p) ≈ 0.5. We can then redefine the single-
period IR, for values of p that are close to 0.5, as
1 
IR ≈ 2  p − (7)
 1 + x 
Equation (7) expresses the single-period IR as a
positive function of p (the probability of correctly timing
the return) and x (the size in case of a profit relative to
the size in case of a loss). Note that in the special case
of x = 1, the IR equals 2p - 1, the definition of IR
for directional forecasts as by Grinold and Kahn [2000,
p. 153]. When x ≠ 1, the risk-adjusted return depends
not only on correctly forecasting the sign of the predic-
tion but also on correctly forecasting the magnitude.
Now that we have established the one-period IR
for a single decision, we can extend the same analysis
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to a multiple-decision setting. The intuition is clear:
For multiple decisions, noise in decision making will
cancel out, and skill in timing will be the average of
p whereas skill in sizing will be average of x, across N
independent investment decisions. To further demon-
strate this, we can see the return-generating process in
Exhibit 1 as a single trial Bernoulli process. For N inde-
pendent investment decisions, each of which generate
return ui with probability pi or return di with probability
(1 - pi ), we can see the process as a repeated Bernoulli
process, which follows a Bernoulli distribution with
mean E( r ) and standard deviation σ( r ). We set N as the
number of independent investment decisions per year
and define the hit ratio (HR) as the number of winning
decisions as a proportion of total decisions, which for N
independent decisions equals p. The win/loss rate (WL),
which is defined as the average return of the wins over
the negative of the average return of the losses for N
independent decisions, equals x.
According to the central limit theorem, when N
is sufficiently large and for returns close to the center of
the distribution, the distribution of standardized returns
of a repeated Bernoulli process will be approximately
Hallerbach [2014], for large N, the IR needs to be scaled
2
by (see also Grinstead and Snell [1997, p. 325]).
π
When N is sufficiently large, and for values of p
close to 0.5 and x close to 1, the IR can be written as
1 
IR ≈ 1.6  HR − N (8)
 1 + WL 
2 8
where 1.6 ~ 2 or
π π
Equation (8) represents the IR as a function of skill
in market timing (HR), skill in sizing (WL), and breadth
(N). The introduction of the WL in the formula for IR
introduces a new dynamic: It is possible to still obtain a
positive IR when the HR is less than 0.5. If the average
profits exceed the average losses by a large enough margin,
the IR would continue to be positive. Conversely, an
investor could make the right decision more often than
not but still be unable to obtain a positive IR as a result of
average losses exceeding average gains. The relationship
between skill and investment results is the same as in any
other game of chance: A player can gain an edge over
The Journal of Portfolio M anagement    27
Exhibit 2
Combination of HR and WL for Incremental Values
of IR (N = 12)
his or her competitors by taking small winnings consis-
tently while limiting the drawdowns and/or by taking
the occasional large win to compensate for smaller, but
more frequent, losses. Either way, once an edge has been
established, the player needs to play as often as possible.
Equation (8) shows that the central insight from the fun-
damental law can be extended: It is important to play
often (high breadth), to forecast the direction correctly
(high HR), and to size exposures well (high WL).
The trade-off between HR and WL is visualized
in Exhibit 2, which shows the curve of combinations of
HR and WL for given levels of IR of a monthly switching
strategy. The area to the right of the IR = 0 line shows
combinations of HR and WL that would lead to a positive
payoff. Exhibit 2 shows that a portfolio manager should
sometimes accept a trade that has a probability of success
of less than 0.5. The IR = 0 line represents the equation
HR = 1/(1 + WL). Hence, a rule of thumb that follows
from Equation (8) is that, if an investment decision has an
asymmetric payoff, the minimum required probability of
success changes from 0.5 to 1/(1 + WL). As an illustration,
in the extreme case of WL = 1.5, the HR can be as low
as 40% for the IR to remain positive. Equation (8) and
Exhibit 2 show that a small increase in skill in timing is
about twice as valuable in terms of risk-adjusted returns
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Exhibit 3
Change to Adjustment Factor when Time Series
of Excess Returns Has Excess Kurtosis
Source: Hallerbach [2014].
as a small increase in skill in position sizing when the WL
is equal to around 1.2 This result does not say anything,
though, about how easy it is to increase skill in either
dimension. Results from behavioral finance studies indi-
cate that behavioral biases can lead to profits being gener-
ated too early and losses being held too long, consistent
with the disposition effect (Shefrin and Statman [1985]).
Presence of the disposition effect in an investment process
would show itself through WL being less than 1.3
FAT TAILS
It is a stylized fact that many financial market time
series exhibit fat tails. Our Equation (8) assumes nor-
mality, so for it to be of practical use, we will have to
allow for fat tails specifically. Hallerbach [2014] derived
the IR under the assumption of a Student t-distribution,
in which the IR depends on the degrees of freedom in
the distribution. When the underlying time series of
returns of the investment strategy or portfolio exhibit
excess kurtosis, the expected return of the time series is
affected less than its standard deviation, lowering the IR.
In terms of our Equation (8), the presence of fat
tails lowers the constant factor 1.6 on the right-hand
side of the equation. For ease of reference, the adjusted
constant factors are given in Exhibit 3. The presence
of fat tails does not alter the structure of the relation-
ship between the factors in Equation (8), although it
does lower the value of IR by up to 12% for any given
combination of HR, WL, and N.
Exhibit 4
Expected IR vs. Delivered IR for 4 Investment Styles in Four Asset Classes
Note: Time period: January 1972 to December 2012. N = 12.
Source: Kolanovic and Wei [2013].
EMPIRICAL RESULTS
To corroborate our findings, we next consider our
theoretical results against empirical results from other
papers.
Kolanovic and Wei [2013] reported risk and return
characteristics of four investment styles across four asset
classes for the time period 1972–2012. They considered
risk and return of traditional long-only, momentum,
value, and carry strategies, implemented in the equities,
bonds, commodities, and currency markets. Exhibit 4
shows the reported Sharpe ratio of each strategy, including
excess kurtosis, HR, and WL.4 The final column shows
the estimated IR based on the reported statistics and
shows a close match to delivered results. The separate
impact of HR and WL on the IR can be demonstrated
by contrasting the three strategy types for the currency
markets. For currency markets, the carry strategy returns
the highest IR, almost fully due to a high proportion
of decisions proving correct (HR = 63%), with the WL
almost equal to 1. The value strategy in currency mar-
kets is right less often (HR = 55%) but compensates by
delivering higher returns when the directional forecast is
correct (WL = 1.14). The momentum strategy achieves a
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higher HR than the value strategy but results in a lower
IR nonetheless because of a lower WL.
Feldman, Jung, and Klein [2015] conducted a fur-
ther study that deals with risk and return characteristics
of active investment strategies. We replicate four of the
strategies mentioned in their paper5 and report the results
in Exhibit 5. Overall, the predicted results in Exhibit 5
show a close match to delivered results. Feldman, Jung,
and Klein [2015] reported a higher IR for the Fed model
versus the CAPE model, for example, although the Fed
model has historically delivered a lower HR than the
CAPE model. The difference in IR is explained by the
higher skew and lower excess kurtosis for the Fed model
versus the CAPE model. The difference in skew and
kurtosis could be the result of the design of the strategy:
The Fed model switches completely out of equities when
a negative period is forecasted, whereas the CAPE model
switches proportionally, meaning it will continue to
include equity sensitivity from crises even when these
are accurately predicted. This depresses the WL ratio and
increases kurtosis on an ex-post basis. Thus, although the
CAPE model is positioned correctly more often than the
Fed model, the latter strategy on an ex-post basis led to
higher IR as a result of the sizing dimension.
The Journal of Portfolio M anagement    29
Exhibit 5
Expected IR vs. Delivered IR for Four Hypothetical Strategies
Note: Time period: January 1976 to December 2016. N = 12.
Source: Feldman, Jung, and Klein [2015].
Exhibit 6
Simulation Results from an Active Switching
Strategy between Equity and Bonds
Note: Time period: January 2000 to December 2016. N = 12.
Overall, Exhibits 4 and 5 show a close match of
expected IR to simulated IR and that the results from
Equation (8) are robust to extreme scenarios (e.g., non-
normality, or the case in which HR is far from 0.5 or
WL is far from 1).
As a final check, we next consider our theoretical
results against simulated results from active strategies
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using a Monte Carlo simulation. We consider an investor
who faces a monthly choice to invest in either equities
(S&P 500) or long-term government bonds (Barclays
Bloomberg U.S. Treasury Index). The monthly return
data span the period from January 2000 to December
2016 and are taken from Bloomberg.
For each strategy, we assume that the investor has
skill in either timing market direction (through varying
the HR) or in sizing (varying the WL). For each com-
bination, we run a simulation with 10,000 iterations.
We report the findings in Exhibit 6. As shown in the
exhibit, the results from Equation (8) are a very close
approximation to the simulated IRs. Skill in calling the
market direction and skill in calling the market size both
have a positive effect on the IR. A 10% increase in skill
in calling the market direction (e.g., HR increases from
50% to 55%) increases IR by 0.26. A 10% increase in
skill in calling the market size (e.g., an increase in WL
from 100% to 110%) increases the IR by 0.13.
PRACTICAL APPLICATIONS
The explicit consideration of skill in position sizing,
through the WL, offers additional insight in measuring
and managing investment performance. The central
insight from this article is that investment success fol-
lows from the breadth of decisions and two distinct types
of skill: skill in forecasting the direction of the market
correctly and skill in sizing positions. The insights from
Equation (8) also have a number of important practical
implications. Investors who record their investment
decisions can use the formula to decompose risk-adjusted
returns into its three components and steer their efforts
for potential process improvements accordingly. The
formula can also be used to decompose a time series
of excess returns into the frequency of outperformance
and the skew in outperformance, allowing these to be
analyzed separately.
CONCLUSION
In this article, we build upon the central insights
of the fundamental law of active management and
decompose the IR into three components: the HR, the
WL, and breadth. The introduction of the WL in the
formula for IR introduces a new dynamic: It is possible
to obtain a positive IR—even when the investor gets
more decisions wrong than right—if the average profits
exceed the average losses by a large enough margin.
We quantify the relationship between the three com-
ponents and show that, from the starting point of the
unskilled investor, increasing skill in market timing
is about twice as valuable as increasing skill in sizing.
The presence of fat tails lowers the IR for any combina-
tion of HR, WL, and breadth, but it does not alter the
structure of the relationship. We apply the decomposi-
tion to different investment strategies across multiple
asset classes and show that the relationship holds with
great accuracy, even when the underlying assumptions
are violated.
ENDNOTES
I would like to thank Ronald N. Kahn for valuable
comments and suggestions.
1
When the distribution of excess returns has fat tails,
the IR is reduced further, with the scaling factors inversely
related to the degrees of freedom of the excess return dis-
tribution. As an example, for a directional timing strategy
in which excess returns follow a Student t-distribution with
five degrees of freedom, the IR must be reduced by a scaling
factor of approximately 26%.
2
The first derivate of IR with respect to HR as a
fraction of the first derivative of IR with respect to WL is
0.5 (1 + WL) 2. Hence, improving skill in market timing is
relatively more valuable if the investor already possesses skill
in position sizing, and vice versa.
3
Another factor that will inf luence the WL is transac-
tion costs. Transaction costs reduce the return in case of a win
as well as the return in case of a loss. If we see transaction costs
as a drag on return, that is, both ln(u) as ln(d) are reduced by
ln(c), then the WL is reduced in the presence of transaction
costs by 2 × ln(c). This implies that the HR after transaction
costs needs to compensate for the drag on return and needs to
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be at the minimum for single-period IR to remain positive,
ln(c )
equal to 0.5 + .
2σ
4
The measure of skewness reported by Kolanovic and
Wei [2013]—the gain-to-pain ratio—is easily converted to
GtP (1 − HR )
the WL as WL = .
HR
5
The leading economic indicator (LEI) strategy is
a switching strategy that is fully invested in the S&P 500
when the Conference Board LEI index rises three months in
a row and switches to being fully invested in three-month
T-bills when the LEI index declines three months in a row.
The yield curve strategy is 100% invested in the S&P 500
if the end-of-the-month yield spread between the 10-year
T-note and three-month T-bill is positive and 100% invested
in three-month T-bills otherwise. The Fed model is based
on the switching strategy of Shen [2003]. If the value of the
spread between the earnings yield of the S&P 500 and the
10-year T-note spread is below its historical 10th percentile,
the portfolio is 100% invested in three-month T-bills; other-
wise, it is invested 100% in the S&P 500. The CAPE strategy
is a switching strategy that invests proportionally more (less)
in the S&P 500 if the ratio of the current Shiller cyclically
adjusted price/earnings ratio (CAPE) falls below (rises above)
its long-term average.
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To order reprints of this article, please contact David Rowe at

drowe@ iijournals.com or 212-224-3045.

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