Hi Guys,
The perennial question is what number or numbers (statistics) are most useful in the mutual fund decision making process beyond the time-tested cost criterion?
Okay, in the complex investment world, the search for a single decisive parameter might well be pure folly. I tend to subscribe to that belief, but although a single parameter is likely never sufficient be itself, it might well serve as an extremely useful sorting mechanism.
What might that parameter be? Recently a lot of attention has been centered on the Active Share percentage that an actively managed mutual fund maintains. Active Share percentage has many attractive features like segregating a truly actively managed fund from a sleeper Index matching alternative. However, much research suggests that actively managed funds do not outperform their more Index duplicating brethren; and they often cost more.
How about Information Ratio as a substitute selection criterion? Or perhaps they can be used in a complementary fashion? What do you think?
The Information Ratio statistic has some persuasive characteristics. Here is a Link to a JP Morgan article that defines and discusses Information Ratio:
https://www.jpmorganfunds.com/blobcontent/518/497/1279234170856_II-IR-KNOW.pdfWhy risk an investment in an actively managed fund product that has not delivered positive Excess Returns? At yet another level, why not invest in a fund that has a low standard deviation in its annual or quarterly Excess Returns? The standard deviation is frequently called Tracking Error and is in the denominator of the Information Ratio.
It seems to me that Information Ratio is superior to the Sharpe’s Ratio as a measure of performance. The Sharpe Ratio is merely a yardstick against the risk-free government bond option investment, whereas the Information Ratio gages performance against a relevant benchmark, so it’s a more demanding test.
Of course, by introducing the need to identify an appropriate benchmark, the Information Ratio adds an uncertainty as to the applicability and the stability of the selected benchmark. There are no free lunches, but this is a hurdle that is frequently addressed and nicely resolved by using available portfolio constituent research tools (I’m thinking of some of Bill Sharpe’s work here)
A constant concern is how much of a manager’s results are luck or skill? Most likely, it is a mixed continuum. There are some stock picking and timing skills within all of us. The Sharpe Ratio likely represents both luck and skill; but the Information Ratio, especially since it must be positive to be included in the sorting process and if the Tracking Error is a small, stable level, is an improved measure of skill alone.
Tracking Error for a talented, skilful fund manager should be a relatively small value. Historical data suggests that the denominator Tracking Error changes slowly over time. That is a skill signal. A reasonable interpretation of this statistical data is that the larger it is, the less skilled and more lucky is that fund manager.
So a high value of positive Information Ratio is an excellent screening indicator when choosing a fund manager (recall that my focus is on the management team and not the fund name).
A remaining issue is the persistence of Information Ratio. Unfortunately, this parameter suffers the slings and arrows of outrageous misfortune. Studies show that it too erodes over time.
There are no permanent free lunches so investing demands investor vigilance. That’s the bad news; the good news aspect of these same studies is that the erosion is usually slow moving. A solid manager doesn’t develop bad habits overnight; sometimes the market just runs away from his style; sometimes irrational exuberance causes unpredictable events.
Here is a Link to a Vanguard study that was designed to explore the Active Share issue, but concurrently examined the impact of the Information Ratio (it’s a rare twofer):
https://pressroom.vanguard.com/nonindexed/active_management.pdfI hope you find these two references meaningful and useful to assist your mutual fund manager selection process. I actually use these data myself in conjunction with other criteria, some not very rigorous or amendable to analyses. In truth, investing decisions can never be reduced to a single factor that applies with equal weight to everyone or every decision.
Incorporating Information Ratio in your screening matrix just might tilt the odds a little more towards more profitable investment fund manager decisions.
Please share your comments on this topic. I seek your opinions. Note that the title to my posting ended with a question mark.
Best Regards.
