In a look back at 2015’s global asset inflows, index-tracker heavyweight Vanguard held on to its leading position in the passive fund industry – sustained and further propelled by the rising popularity of index strategies.
But as with any business, the growth of one sector hinders another. The popularity of index funds has forced the active investment industry to justify its active fees. With this, we have seen the increasing use of active share on factsheets – intended as this justification.
But alone, active share justifies little. It is only through the combined use of tracking error and R-squared that investors can arm themselves with the reliable tools to identify genuine active managers.
Tracking error measures the standard deviation of a fund’s excess returns over an index or benchmark portfolio – below two suggests a passive approach. At three and above, the correlation indicates true activeness.
The R-squared measure indicates how closely correlated a fund is to an index or a benchmark. As a percentage, it shows the proportion of a fund’s movements that can be attributed to those of the benchmark. Close to 0 per cent indicates no correlation and 100 per cent shows a perfect match.
Both R-squared and tracking error measure activeness and, therefore, should provide identical information. If you use these to assess the IA UK All Companies sector, there is a strong (negative) correlation between the two.
Although there is a strong relationship between these two ratios, investors ought to combine both to decipher true activeness.
Let’s compare two imaginary managers – both have an annualised tracking error of five against a similar benchmark, but their R-squared differs. Manager A has an R-squared of 75 per cent while Manager B has an R-squared of 85 per cent. Which should investors pick?
A simple solution would be to go for Manager A. But it could mean Manager A takes more stock-specific risk than Manager B. But what if Manager A inflates tracking error by allocating to off-benchmark positions? This is not a desirable feature as it could indicate a deviation from its investment mandate.
Looking at the historic development of these ratios for funds in the IA UK All Companies sector over the last five years, typically there is always a strong relationship between tracking error, R-squared and active share.
However, in 2015 it appears UK equity managers took more active risk with an increased tracking error. But, the R-squared increased too.
This suggests the typical UK equity manager also took on more market risk. The fall in materials stocks that drove the market in the second half of 2015 goes some way to explaining this – a sector typically avoided by UK equity managers.
The influx of active share being included in factsheets alone should mean little to investors. Those wanting to assess true activeness are better off using tracking error and R-squared to break down the active risk between market/systematic risk and stock-specific/unsystematic risk.