In addition, investment management fees need to be incorporated into product evaluation as certain strategies have higher fees than others. The management fee for any strategy should be consistent with its target excess return. As multiple strategies have emerged between passive indexing and fundamental active, excess return and fees have taken on a linear relationship. Typically, the more excess return the strategy has produced, the more investors have paid in fees. Comparing Net-of-Fee Information Ratios can help gauge the efficiency of the different strategies. But again, focusing on this measure in isolation can be misleading.
An example can help place the relationship between these measures in perspective. As "Risk/Reward Analysis of Three Large-Cap Equity Strategies," page 17, shows, a hypothetical investor's goal is to generate 100 basis points in excess return over the return of the S&P 500 and is presented with three different methods for achieving this:
- The first strategy is an Index Plus approach that has an excess return of 50 basis points and a targeted tracking error of 50 basis points.
- The second approach is a stock-based Enhanced Index strategy that has an expected excess return exceeding that of Index Plus yet still in a risk-controlled manner.
- The third strategy is a Fundamental Active approach that potentially can create 175 basis points of excess return with a tracking error of 425 basis points.
Which strategy is most appropriate for an investor with an objective of 100 basis points of excess return after fees? In our example, Index Plus has the highest Information Ratio of 1.00 and is presumably the most efficient. Even after fees, Index Plus seems to be the best choice with an Information Ratio of 0.80. However, while the Index Plus strategy is efficient, it does not meet the investor's excess return goal of 100 basis points.
|Performance analysis measures can be used to evaluate the relative success and efficiency of an investment product.
|Excess Return: the total
return of a strategy minus the
benchmark index total return.
|Tracking Error: a risk
measure of the variability
of a strategy's total return
around the benchmark index.
Or, the standard deviation
of a strategy's historic
a measure of risk-adjusted
return relative to the
Ratio is calculated by
dividing the excess return
by the tracking error.
Ratio: a measure of a
strategy's performance against
risk and return relative to its
benchmark after deducting
fees. It is calculated by dividing
the net-of-fee excess return by
the tracking error.
The Index Plus strategy only creates 40 basis points of excess return after fees are deducted, which is 40% of the investor's performance goal. We believe adjusting the Information Ratio down to take into account both the strategy's excess return and the investor's performance goal creates a better comparison across strategies. In the example, similar adjustments need to be made to the Enhanced Index and Fundamental Active strategies.
By comparing the strategies' Adjusted Information Ratios, there appears to be no clear winner. Each strategy has its trade-offs — either not enough excess return or increased risk as evidenced by higher tracking error:
- The Index Plus strategy can produce return more efficiently,
but it falls well short of the investor's excess return target.
- The Enhanced Index strategy is closer to the investor's
minimum excess return target, but still does not reach 100 basis points of excess return after fees.
- The Fundamental Active strategy does produce excess return greater than the return target, but creates the most tracking error of all the strategies.
So what conclusions can we draw from this example? Today, investors have options not only in strategies to reach a target excess return goal but also in implementation of those strategies. Individually or combined, each of the
five strategies shown in the "Strategies for Large Cap Equity Exposure" chart on page 14 has the potential to meet an investor's return objective. Investors should have an idea of the excess return desired to meet financial goals or funding requirements, but searches should not be based solely on that absolute target.
Structuring a mandate to consider a broad spectrum of strategies can provide multiple options to achieve investment needs. Doing so also diversifies the sources of alpha because the excess return in each strategy is created so differently. For example, the excess return created from an active strategy has a low correlation to the excess return created from a derivative-enhanced strategy. Investors can use a combination of strategies to reach their target, while in the process creating a more diversified aggregate large cap exposure with less active risk.
Needing a large amount of excess return from an asset class does not always require selecting a high excess return strategy or a combination of strategies. Typically, there is a positive relationship between excess return and tracking error, with higher excess return strategies having lower Information Ratios.
|"Investors need to look beyond the traditional
‘siloed' investment manager searches and compare strategies across the broad
spectrum of approaches available today."
—Laura Lawson, product manager,
With leverage and derivatives becoming more mainstream and accessible, excess return goals can be met by using risk-controlled strategies. Leverage can be employed to increase the excess return from any strategy and derivatives used to remove unwanted equity exposure. A creative solution for the investor in our example needing 100 basis points of excess return would be to lever up the highly efficient Index Plus strategy three times. Leverage and derivatives create the ability to financially engineer excess return within a certain risk budget.
Excess return is not guaranteed in today's market, and it has become challenging for institutional investors to find managers and strategies that can create the desired return. As a result, investors need to look beyond the traditional "siloed" investment manager searches and compare strategies across the broad spectrum of approaches available today. This means selection should not be made on the basis of any one performance measure. Despite the current popularity of the Information Ratio, investors can't spend the ratio. Instead, investors need to consider an array of performance measures when evaluating across strategies.
Expanding the opportunity set so that different strategies within a single asset class can be compared provides choices in implementing asset class exposure within a risk budget. Investors can select a single strategy, use a combination of strategies or engineer solutions through leverage to create efficient asset class exposure.