What has become known as the active-passive debate is now a foundational discussion posing an existential threat to some within the investment industry.
The issue raises fundamental questions of what is to be expected of asset managers. Should they be using their superior skill to outperform the market, or should they accept the more modest role of simply tracking indices?
I believe UK equities offer the most fertile ground for successful active managers. The information ratio is the most useful metric to look at when analysing the capacity of an active manager to outperform a benchmark.
It is a versatile and useful risk-adjusted measure of actively managed fund performance, and assesses the degree to which an active manager uses skill and knowledge – as measured by its tracking error – to enhance the fund’s returns.
The metric is calculated by deducting the returns of the fund’s benchmark by the vehicle’s overall returns. This result is then divided by the fund’s tracking error, which is a measure of the volatility of the product’s excess returns.
For each unit of extra risk assumed, the value that is arrived at is an expression of the success of the manager’s decisions (tilts) away from the benchmark.
The higher the information ratio, the better. It is generally considered that a figure of 0.5 reflects a good performance, 0.75 is very good, and 1 is outstanding. My research also took into consideration the investment period, as the length of holding an active fund could vary between managers.
The first observation to make is that, despite being very difficult, it is possible to find a few active managers who have proven their skills over time.
One-fifth of UK funds in both the UK All Companies and UK Equity Income sectors have an information ratio in excess of 0.5 over the past five years. This falls to 3.9 per cent and 4.9 per cent, respectively, over three- and one-year periods, though it should be noted that the surprise Leave vote and subsequent market movements may have had a bearing on the latter figure.
Across the study we further observed that the active funds which performed well over the past six months or one year were different to the ones outperforming during the past three or five years.
The market rotation towards value in 2016 was probably one of the predominant drivers for these differences.
The figures also suggest investing with an active manager for a period of five years, instead of the typical three-year investment period, is more worthwhile.
A five-year investment period better corresponds to an entire business cycle. The numbers show that information ratios significantly improve over five years, though it would appear almost impossible for skilled active managers to outperform across an entire decade.
As with the absolute return sector, it is possible to pick a skilled equity manager who adds return in excess of the active risk – or cash for absolute return. Therefore, it is clear that UK equity investors have a good chance of selecting a genuinely skilled active manager over a business cycle.
Charles Younes is research manager at FE
