What does the Fundamental Law of Active Management (FLOAM) express?

• A. The method for calculating liquidity risks
• B. The value added by a portfolio manager based on skill and breadth
• C. The correlation between different asset classes
• D. The process for merging funds

Answer: (B)

The Fundamental Law of Active Management (FLOAM) fundamentally assesses the value added by a portfolio manager through their unique insights and strategies. It highlights the relationship between a manager's skill level, represented by the information ratio, and the breadth of their investment decisions, which reflects the number of independent investment opportunities they pursue.

This law posits that the excess return generated by an active manager (the added value) is directly proportional to both their skill (or ability to generate alpha) and the number of decisions made (breadth). In simple terms, a skilled manager who makes a high number of decisions is positioned to create substantial excess returns.

In contrast, the other options relate to different concepts in finance and do not accurately embody the essence of FLOAM. Liquidity risks pertain to the ease of buying or selling assets without affecting their prices, while correlations between asset classes and the merging of funds address different aspects of investment analysis and strategy formulation. Therefore, the emphasis on skill and breadth directly aligns with the core tenet of the Fundamental Law of Active Management.