The relevance of Information Ratio in selecting active equity funds

The Information Ratio is a measure used to evaluate the performance of an investment portfolio against a benchmark index, adjusted for risk.

One finds a lot of chatter on social media and elsewhere around the latest star manager or star fund house, whichever is blowing the lights out on recent performance, and every year or two, the cast in this story keeps changing.

The challenge in selecting actively-managed equity funds is not so much about the lack of alpha, but the variability of alpha and swift rotation of winning managers generating alpha from time to time. Now, someone new is at the top of the alpha league table every other year, and there is a lack of consistency in alpha generation.

Having such wild winner rotation in the alpha league table with rarely anyone sustaining alpha generation is as good as not having alpha. It makes the process of fund selection very hard, and sticking to selected funds even harder because we all want to be on the ‘winning’ team.

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Taking a cricketing example, if every batsman has an excellent batting average over time, you might think you are endowed with great depth of batting talent. But every time you pick a team and enter the match, very few batsmen score above average, and in every game, a different set of batsmen deliver above their average. How do you pick a team?

The bench looks very strong. The team management believes we have the right talent, a winning team but one that is unable to create a winning performance. What is the use unless there is consistency? You are much better off having a bench with a lower average but high consistency.

Even an adult can drown in a river with an average depth of five feet, because the depth at the deepest end is what matters while crossing the river, and not the average depth. In investment terms, the average alpha is not important but how much drawdown in alpha you inflict on the portfolio at the worst is what will determine investor experience. Just because a manager has a high average alpha, it doesn't mean they are reliable contributors to a portfolio's success or to the investor’s experience with that manager.

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The Information Ratio, disclosure of which has been mandated by Sebi recently, addresses this very concern for investors, offering a sophisticated tool that emphasizes reliability and consistency in performance over mere averages.

The Information Ratio is a measure used to evaluate the performance of an investment portfolio against a benchmark index, adjusted for risk. It is calculated by dividing the portfolio's excess returns over the benchmark by the tracking error, which is the standard deviation of the excess returns.

In simpler terms, it is alpha divided by the standard deviation or measure of variability of alpha, and it tells investors how much additional return they are receiving for the extra risk taken by deviating from the benchmark.

Interpreting the Information Ratio

We don't need highest alpha if it comes with high variability, i.e. huge positives followed by huge negatives. What we need is consistent alpha with low variability. Focus on information ratio breaks a highly prevalent myth – i.e. fund performance depends on stock picking chops alone.

Studying variability of fund performance vis-à-vis benchmark leads one to understand that fund management is not just about picking stocks that will deliver returns higher than the rest or identifying multi-baggers to maximize returns. Portfolio construction relative to benchmark is more important for good investor experience.

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We need good treatment to cure an illness, but treatments that jeopardize a patient’s tolerance and well-being often come at unacceptable cost, i.e. the patient losing belief in the treatment and their ability to overcome the illness. When faced with extremes of fund performance, investors find it difficult to stick to their investment because extremes evoke emotions and emotions cause mistakes in investing.

Investors tend to invest in funds with the highest alpha (greed) but this highest alpha comes with a very high deviation from the benchmark, abandoning the balance of the portfolio and aligning the portfolio totally in favour of what’s in vogue in the market or what’s currently ‘hot’ or ‘trending’ in markets. When macroeconomic environment changes, what works in markets changes and what works within the benchmarks also changes.

This would result often in the manager with highest alpha falling to the bottom and someone at the bottom-end rising like a phoenix. When the manager with the highest alpha becomes a fallen star, money starts to flow out (fear) and chase the phoenix. The chase for the best performer is never ending. We don’t need the best performer, we need the consistent performer. Someone with above average alpha but low variability.

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Someone who is in the top quartile when portfolio positions or investing preferences are aligned with market conditions, and bottom of second quartile or top of third quartile when portfolio positions or preferences in investing are not aligned to market conditions.

A higher information ratio indicates a more desirable risk-adjusted performance, signalling that the manager's active decisions are yielding beneficial results more consistently against the benchmark despite the risks involved. Picking funds with healthy information ratio (>0.5 is acceptable and >1 is great) ensure investors are not exposed to extremes of performance, they get consistent experience and can stay put for longer to enable compounding of investment.

The author is the Chief Executive Officer of WhiteOak Capital AMC

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.