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Active vs passive funds

Active vs passive funds

At a recent funds conference, a debate took place about active versus passive investments.

The conclusion was the same as always: investors should consider a mix of active and passive investments.

It is straightforward to gauge the performance of passive funds – since the objective of these funds is to track their benchmarks, the tracking error of these funds will show whether they have been successful in doing so or not.

However, to do the same for active funds is not as simple.

For these funds, the information ratio is a great (if not the best) metric to use.

It is a versatile and useful risk-adjusted measure of actively managed fund performance. It assesses the degree to which a manager uses its active skills and knowledge to enhance the fund returns. 

The ratio is calculated by deducting the returns of the fund’s benchmark by the fund’s overall returns.

This result is then divided by the fund’s tracking error, which is a measure of activeness.

 

The value that is arrived at is an expression of, for each unit of extra active risk assumed, the success of the manager’s active decisions away from the benchmark. The higher the information ratio, the better.

It is generally considered that a figure of 0.5 reflects good performance, 0.75 very good, and 1 outstanding. 

Its versatility 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. 

As a result, I decided to run my performance analysis on 22 Investment Association 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.

The table below shows the results of some of my calculations, using different investment horizons (three, five and 10 years). 

Performance from the different sectors gives us a good idea on what an average active fund manager would have achieved over these different time periods.

Over the different time periods, fund managers in the UK Equity Smaller Companies, Japanese Smaller Companies and North American Smaller Companies 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. 

It also appears that managers struggle when they are offered geographical flexibility. The performance of an average manager in the Global, Global Equity Income and Global Emerging Markets sectors have been consistently negative.

This makes sense as the managers 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, as it requires additional skills: understanding the macro environment as well as country dynamics.