Financial experts have long debated whether investors should go down the active or the passive route when it comes to selecting their investments. The benefit of passive funds can largely be put down to the lower fees they charge over their active counterparts. On the contrary, the benefit of an active fund is that, while more expensive, it offers the possibility of outperforming the benchmark and returning greater profits to the investor.
When it comes to looking at how well a fund is performing and deciding if it is proving its worth, passive investments are easy to analyse. As their objective is to track the performance of a benchmark, we look at the tracking error to compare how well they do this (the difference between the return of the fund to that of its benchmark). The lower the tracking error, then, the closer the fund tracks its benchmark performance.
It is not so simple, however, to analyse the performance of an active fund because these can have very different objectives and there are a host of different metrics we can use to analyse their performance. One of the most effective, in my opinion, is the information ratio. It assesses the degree to which a fund manager uses their active skills and knowledge to enhance the return of the fund. Information is a versatile and useful risk-adjusted measure of actively-managed fund performance.
The ratio is calculated by deducting the return of the benchmark by the fund’s return. The result is then divided by the fund’s tracking error, which is a measure of activeness. The result can be looked at as an expression of the success of the manager’s active decisions away from the benchmark for each unit of extra active risk assumed. The higher the information ratio, the better and we generally considered that a figure of 0.5 reflects good performance, 0.75 very good, and 1 outstanding.
Nevertheless, this metric is not without its drawbacks and, if any discrete reliance is to be placed on the information ratio, the r-squared correlation between the fund and its benchmark must be strong. The versatility of the information ratio, however, comes from the point that ‘added value’ does not necessarily mean value added to the fund’s own benchmark. Analysts can decide which benchmark or index they wish the fund to outperform and adjust the statistics accordingly.
Following this, I decided to run my performance analysis on 22 Investment Association (IA) sectors where relative performance could be meaningful. I also decided to compare all the funds within the same sector to a common benchmark, to avoid the benchmark selection bias. Below is the summary of my calculations, using different investment horizons (three, five and ten years).
By looking at the performance of the different sectors, we can get a good understanding of what an average active fund manager would have achieved over these different time periods. The first lesson from this table is that the small-cap equity markets are far from being efficient. Over the different time periods, fund managers in the UK Smaller Companies, Japanese Smaller Companies and North American Smaller Companies sectors have managed to return a positive information ratio. A caveat to this is the small breadth of those sectors as the number of funds is limited.
Another point to note from the results is that managers struggle when they are offered geographical flexibility. The performance of the average manager in the Global, Global Equity Income and Global Emerging Markets sectors has been consistently negative. This makes sense, as managers operating within these sectors not only need to get the stock picking and industry allocation right, but they also need to be accurate in their country exposure. Investors should think twice before giving an active manager the opportunity to invest across countries, because it requires additional skills: an understanding of the macro environment as well as country dynamics.
It is also interesting to note that the performance of an active manager significantly improves as we increase the investment horizon. Over the last ten years, 51.70 per cent of the funds in the IA have produced a positive information ratio, while this number decreases to 33.62 and 26.07 per cent over the last five and three years respectively. I suspect my study may suffer from survivorship bias, which can lead to overly optimistic beliefs because failures such as fund closures are ignored. Nevertheless, there is a clear trend that can’t be ignored. Investors should hold their investments over a long time because frequent fund turnover as a knee jerk reaction to market movements might cause more harm than expected.
To conclude, while it is clear that active managers can provide value over the long term, I firmly believe that the best way to invest is to use a mixture of active and passive investments. The two are complementary to one another and you can see this philosophy put into practice at FE Invest. Our model portfolios combine active and passive funds to provide the best possible blend of funds that meet investors’ objectives.
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