Active managers try to generate a return above a given benchmark by holding securities in weights different than the benchmark. The active return on a portfolio is the return on a portfolio minus the benchmark’s return.
Multifactor models help us understand the sources of a manager’s return relative to a benchmark. Analysts favor fundamental multifactor models to decompose the sources of returns as they are easier to explain compared to statistical models.
Using a factor model, we can decompose a portfolio manager’s active return as the sum of two components:
The following equation shows the decomposition of active return into these two components: