Correspondence: Wolfgang Drobetz, Institute of Finance, University of Hamburg, Von-Melle-Park 5, Hamburg 20146, Germany. E-mail: wolfgang.drobetz@wiso.uni-hamburg.de

¹has been a partner at alpha portfolio advisors GmbH since 2002. His focus in advising institutional clients is on Alternative Investments and Manager Selection for Hedge Fund Mandates. Dr Dichtl holds a masters degree in Informatics and Business Economics and has earned his doctor's degree in 2000 in the Finance Department of the University of Bremen. Dr Dichtl is author of the book 'Ganzheitliche Gestaltung von Investmentprozessen' and co-editor of the handbooks 'Hedge Funds' (2005) and 'Asset Allocation' (2003) as well as author of several professional papers on asset management topics.

²holds the chair for Corporate Finance and Ship Finance at the University of Hamburg. Previously, he also taught at the University of Basel, the University of St. Gallen, and the WHU Otto Beisheim Graduate School. His research interests are Corporate Finance, Asset Pricing and Asset Management. He is a member of the editorial board of the European Journal of Finance and served as co-president of the European Financial Management Association (EFMA).

Received 19 October 2008; Revised 19 October 2008.

Abstract

The performance potential of forecasting-based tactical asset allocation strategies is difficult to assess. The fundamental law of active management suggests that the value added through active investment decisions depends on the forecasting quality and the number of independent forecasts. Although easy to use, the law depends on several specific assumptions that are not fulfilled in practice. Therefore, it is not clear ex ante whether the actual performance of tactical asset allocation is close to what the fundamental law predicts. Using a simulation approach, we quantify the entire distribution of information ratios, active returns and tracking errors under realistic conditions (for example, with transaction costs and tactical bounds rather than a simple mean-variance optimisation). Our results reveal that the fundamental law systematically underestimates the required forecasting quality to reach a very good information ratio. While all other assumptions of the law seem innocuous, transaction costs are responsible for most of the wedge between the law's prediction and the performance of tactical asset allocation in a realistic setup. Our results are robust for stock and bond market data from different countries.