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Unlike traditional asset classes, most alternative assets are not actively traded, whether they are held directly or held through investment pools. Even investment pools with liquid underlying assets (e.g., CTAs and long/short equity hedge funds) are typically not liquid. Therefore, there are costs associated with actively managing portfolios that consist of alternative assets. This section introduces implementation costs into FLOAM.

The FLOAM as expressed in Equation 2.1 assumes that the manager faces no constraints in the asset allocation decision. If one were to take into account that some allocations may have to be substantially different from the ideal allocation recommended by the manager's forecasting skill, an extended FLOAM can be rewritten as:

(2.2)

where TC is the transfer coefficient. TC measures the ability of the manager to implement her recommendations.10 The upper limit for TC is one, and the lower limit is zero. When TC is equal to one, it means the manager is able to implement all her recommendations. Clearly, TC will be less than one when a portfolio of alternative asset classes is considered. Both hard constraints, such as no short selling of funds, and soft constraints, such as high transaction costs associated with the rebalancing of alternative assets, will reduce the value of TC well below one.

APPLICATION 2.1.2

Consider two similarly skilled active managers, each with an IC of 0.50. Active manager C can apply his skills to only 16 asset classes, whereas active manager D can apply her skills to 100 securities. What level of transfer coefficient does each manager need to have in order to generate an information ratio of 1.2?

Using Equation 2.2:

Active Manager C:

Active Manager D:

By having greater breadth, active manager D can achieve an IR of 1.2 with a TC of only 0.24.