Active Management and Benchmarking
One of the most important results of the above analysis is the last line in Equation 26.31. It can be written in the form
Based on this equation, the expected excess returns of all assets are explained solely by their betas with respect to the optimal portfolio and the return of the optimal portfolio itself. This is very remarkable. Within the framework of classical Mean-Variance portfolio theory there is not much freedom for the individual assets. The optimal portfolio drives everything. The question now remains, what this optimal portfolio exactly is. The argument in the following paragraph leads to an identification.1
KeywordsInternal Model Optimal Portfolio Excess Return Residual Risk Market Portfolio
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