“Gladden: Because TRS’s investment policy prohibits short positions, TRS would be unable to take
advantage of any optimized portfolios with increased active risk.” Please explain this line.
Do we short portfolios with active risks more than our optimal active risk? Is this what the sentence mean?
Optimal Active risk is the risk which if a PM takes his/her TC will be 1 i.e., he/she gets the liberty to adjust the weights & select the sec., with complete independence i.e., no constraints being imposed by investors. But, in case an investor imposes some constraint, PM is not able to realise his/her expectations the way it wants to.
We short less in case of actual than what we would have if there was no constraint i.e., if optimal AR was taken.
I hope this explanation helps you. Thank you!
One more way to think about this could be like, what is an optimum portfolio for us, considering the active risk we want to take that is our desired active risk? We basically adjust the weights between the active portfolio and the benchmark according to the extent of active risk we want to take. So now let’s say we want to take more risk than the active risk, that is they are offering 20% but we want to take an active risk of 30%. In this case what we do is we invest 150% in the active risk portfolio and short 50% of the benchmark, right? But since we can’t short, this acts as a constraint, and we are unable to do so even if we want to.
Hence, concluding your point too, we don’t short portfolios with active risks more than our optimal active risk, we basically reduce the proportion and add the benchmark portfolio (75%,25% respectively or 60%,40% and so on) to reach our optimum active risk/desired risk.
I hope this help!