Is it possible to find a simple measure that identifies skilful active managers and thus funds that will produce good returns? This is what the information ratio was meant to do, but several studies have shown there is no relationship between it and future fund performance.
Research by Martijn Cremers and Antti Petajisto of Yale School of Management, recently endorsed by Morningstar, finds a strong link between “active share” – the extent to which a fund’s holdings differ from its benchmark’s - and performance.
Unlike the information ratio, which simply measures performance per unit of volatility, Cremers and Petajisto’s “active share” looks at what is inside portfolios then finds robust links between portfolios’ profiles and future performance.
The two researchers looked at the performance of 2,740 all-equity US mutual funds from 1990 to 2009. They found that diversified stock pickers - funds with high active share but not the very highest tracking error - performed best, producing an average yearly benchmark-adjusted return over the period from 1990 to 2009 of 120 basis points after taking away all expenses and costs.
Meanwhile, funds with low active share, termed closet indexers by the researchers, showed an average yearly benchmark-adjusted underperformance of 89 basis points over the same period on the same basis. Interestingly, Cremers and Petajisto’s research also found that portfolio turnover was comparatively high among closet indexers, while diversified stock pickers showed a much lower level of turnover.
Active Share and Mutual Fund Performance, Martin Cremers, Yale School of ManagementView Webcast
Active share, an alternative to the information ratio, Peter Elston, Strategist, Aberdeen Asset Management Asia LimitedView Webcast
Active management and the power of compounding, Peter Elston, Strategist, Aberdeen Asset Management Asia LimitedView Webcast
The impact and implications of the growth of passive investing, Peter Elston, Strategist, Aberdeen Asset Management Asia LimitedView Webcast