Estimation Error and the "Fundamental Law of Active Management": Is Quant Fundamentally FLawed?

Richard O. Michaud, David N. Esch, and Robert O. Michaud

According to widely referenced applications of Grinold (1989) “Fundamental Law” theory, simply adding securities to an optimization universe, adding factors to a forecast return model, trading more frequently, or reducing constraints can add investment value to an optimized investment strategy.  We show with intuitive discussion followed by Monte Carlo simulation that many applications of Grinold theory for optimized portfolio design are often unreliable and self-defeating.  Critical limitations of the theory are due to ignoring estimation error (Michaud 1989) and constraints required in practical applications.  A substantial fraction of professional actively managed funds may be negatively impacted.