What it means
Every actively managed fund is measured against a benchmark, and the difference between the two is where the entire argument lives. Beat the benchmark after fees and the manager has earned the mandate; fall short consistently and the investor would have been better off in a cheap index product.
The manager's raw material is a set of active positions, meaning holdings that differ in weight from the benchmark. Overweighting a company means believing it will outperform, underweighting or excluding it means the opposite, and the sum of those decisions determines the fund's excess return.
Risk is measured differently here than in ordinary investing. Tracking error, which is how much a fund's returns wobble around its benchmark, describes how far a manager strays; a low tracking error means small bets, while a high one means the manager is willing to look very different from the index.
The standard scorecard combines the two. The information ratio divides excess return by tracking error, answering whether the manager is being rewarded for the risk taken relative to the benchmark rather than simply making bigger bets and getting lucky.
A persistent criticism is closet indexing, where a fund charges active fees while holding a portfolio that barely differs from its benchmark. Such funds are almost mathematically certain to underperform after fees, which is why measures like active share have become common in fund selection.
In practice
Real-world examples
Example 1
A charity's investment committee reviews two equity managers. Both beat the benchmark by about 2% a year, but one did so with a tracking error of 4% and the other with 11%, so the committee retains the first and reduces the second.
Example 2
A corporate pension scheme discovers its actively managed UK equity fund holds 94 of the benchmark's 100 constituents at almost identical weights while charging 0.75%. It moves the money to an index tracker at 0.07% and keeps the risk profile virtually unchanged.
Example 3
A fixed income manager runs a portfolio with duration deliberately shorter than the benchmark ahead of expected rate rises. The position is the single largest driver of the fund's excess return that year, illustrating that active management is not only about picking individual securities.
Think of it
Active management is hands-on investing-making decisions to try to beat the market rather than just matching it.
Formula
Calculation
Information ratio = (portfolio return - benchmark return) / tracking error
A global equity fund returns 12.2% over the year while its benchmark returns 9.7%. Excess return is therefore 12.2% - 9.7% = 2.5%.
The fund's tracking error, measured as the standard deviation of its monthly excess returns annualised, is 5.0%. The information ratio is 2.5% / 5.0% = 0.5, which is generally regarded as a decent result for a long only equity manager.
A second manager also delivers 2.5% of excess return but with tracking error of 10.0%, giving an information ratio of 2.5% / 10.0% = 0.25. Both look identical on headline performance, yet the first manager achieved the same result with half the deviation from the benchmark, which is the more repeatable outcome.Case study
Seen in the real world
The following example is illustrative and fictional. The trustees of the Ashworth Foundation, an invented endowment with $220,000,000 invested, held six actively managed equity funds and had never compared them on a consistent basis. Each manager reported against a slightly different benchmark and over a period that suited them.
An adviser rebuilt the analysis over a common seven year window. Three funds had information ratios between 0.35 and 0.55, one was close to zero, and two had negative ratios while charging above 0.9%. One of the negative funds turned out to have a tracking error of just 1.8%, meaning it was charging active fees for something nearly indistinguishable from the index.
The illustrative trustees consolidated into three managers and an index fund, cutting the blended fee from 0.81% to 0.42%. On $220,000,000 that saved roughly $858,000 a year before any change in performance, which the trustees described as the only certain return available to them.
Watch out
Common mistakes
- Assuming a high fee guarantees genuine active management, when some expensive funds hold portfolios almost identical to their benchmark.
- Judging managers on absolute return in a rising market, when the relevant question is performance against the benchmark net of fees.
- Firing a manager after one poor year, since even skilled managers underperform in roughly one year in three purely through style cycles.
Questions
People also ask
What is a good information ratio?
Around 0.5 is considered solid for a long only equity manager and anything sustained above 1.0 is rare and impressive.
How is active management different from active investing?
Active management usually describes the professional running of other people's money against a benchmark, while active investing is the broader idea of making deliberate investment choices.
Does active management work better in some markets than others?
Yes, managers have historically found more room in smaller companies, emerging markets and corporate credit than in large, heavily researched listed shares.
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