The top 20 UK funds with the highest tracking error to the FTSE All Share over five years have comfortably outperformed those with the lowest tracking error, according to the latest FE Trustnet study.
The study was based on two composite portfolios of active funds in both the IA UK All Companies and IA UK Equity Income sectors, one of which was the 20 funds with the highest tracking error – standard deviation of a fund’s excess returns over the returns of an index – relative to the FTSE All Share index, and the other was the 20 lowest.
The portfolios of funds with the highest tracking error comfortably has outperformed over one, three and five years. Over five years, the funds returned an average of 66.71 per cent while the lowest tracking error funds returned 44.62 per cent.
However, both sectors have outperformed the benchmark over this time frame, which returned 35.45 per cent.
Performance of composites vs benchmark over 5yrs
Source: FE Analytics
The debate around active versus passive funds has greatly increased over recent years, thanks largely to the introduction of the Retail Distribution Review (RDR) in 2013 led to a greater awareness of closet trackers and costs.
While the argument for passive investment is that it is cheaper and more reliable than active funds, investors are keeping a watchful eye on how active their manager is and whether they are getting the service and due diligence they are paying for.
While active share has been the most popular way of assessing how ‘active’ active managers have been in 2015, tracking error has tended the most widely used metric over recent years.
According to our research, it seems that active management and straying away from the benchmark could well optimise returns – the data also found that the composite portfolio of high tracking error funds had a much higher Sharpe ratio, which measures risk-adjusted performance, and a higher alpha ratio, which measures the returns achieved in addition to the benchmark.
Source: FE Analytics
All 10 of the funds with the highest tracking error have beaten the index over five years, as the table above shows.
However, the high tracking error composite had a higher annualised volatility and a higher maximum drawdown, which measures the most money an investor could have lost had they bought and sold at the worst possible times.
Meera Hearnden, senior investment manager at Parmenion, says that these results are not surprising and in fact, she would expect funds that are taking greater risks to outperform.
“You need to be careful when running these types of numbers though as the performance could have been achieved in one short period making the longer term performance look attractive,” she warned.
“When you look at funds using rolling performance data, this can often tell you a different story. Rolling data as opposed to cumulative data is often a good way to show how consistent a fund has been in delivering the performance.”
It must be noted that, on a discrete annual calendar basis, the composite of funds with the highest tracking error outperformed in rising markets such as in 2010, when it doubled the performance of its peers with a low tracking error.
Performance of composites in 2010 vs benchmark
Source: FE Analytics
But, the composite portfolio significantly underperformed in 2011 during the throes of the European sovereign debt crisis, losing an average of 11.37 per cent compared to the low tracking error composite’s loss of 3.97 per cent and the FTSE All Share’s loss of 3.46 per cent.
This behaviour isn’t too surprising though, given that many of the funds in the high tracking error composite are recovery funds such as MFM Slater Recovery and Standard Life Investments UK Equity Recovery, which are renowned for falling harder during bear markets given their styles.
Some of the funds also have a small and mid-cap bias, such as Unicorn UK Growth, Unicorn UK Income and Schroder UK Mid 250.
The fund with the highest tracking error overall was in fact Standard Life Investments UK Equity Recovery, which has five FE crowns and has been managed by David Cumming since its launch in 2009.
Over this time, it has returned 212.4 per cent, outperforming its peer average in the IA UK All Companies sector by 56.78 percentage points.
Performance of fund vs sector since launch
Source: FE Analytics
However, it is also in the bottom decile over the same time period for its annualised volatility, its Sharpe ratio and its maximum drawdown, which is more than double that of its sector average.
On the opposite end of the spectrum, the fund with the lowest tracking error came out as Scottish Widows Multi-Manager UK Equity Income, which has been managed by the Aberdeen Investment Solutions team for the last seven months.
Since then, it has underperformed its sector average by 1.52 percentage points, having made a loss of 1.98 per cent, but it has outperformed the FTSE All Share, which lost 4.01 per cent over the same time frame.
While it is in the second quartile for its annualised volatility and maximum drawdown under its current management, this is arguably a short period of time to measure such ratios in. Over five years, which includes when Lyndon Gill and Andrew Perham were at the helm of the fund, it remains in the second quartile for both its drawdown and volatility.
Source: FE Analytics
Investors’ risk appetite is one factor that should be taken into account, and it should also be noted that there are inevitably funds with low tracking errors that have significantly outperformed, and funds with high tracking errors that have drastically underperformed.
Patrick Connolly, head of communications at Chase de Vere, is unsurprised that the high tracking error composite has outperformed, but says that he expects funds with the highest tracking errors to be both at the top and bottom of the performance tables.
“This is because they deviate the most away from the benchmark and so deviate away from most competitor funds,” he explained.
“Whether the funds find themselves at the top or the bottom depends solely on whether the fund manager has made the right or the wrong calls.”
A prime example is Manek Growth, which sits in the IA specialist sector and has a tracking error of 17.44 per cent versus its FTSE All Share benchmark, compared to Standard Life Investments UK Equity Recovery’s tracking error of 13 per cent.
Despite significantly outperforming its peer average at the turn of the millennium, the now £12.6m fund bombed after 2001. Since its launch, it has lost 46.64 per cent, compared to the FTSE All Share’s return of 152.78 per cent.
“We are supporters of genuine active fund management in those areas where we think it can add real value,” Connolly said.
“However, what is most important is understanding the approach a fund will take before you invest. If you select a fund where the manager takes big bets you have to accept that there are likely to be periods when they could significantly outperform but also periods when they could significantly underperform.”
Hearnden adds that, while tracking error is fine to use if an investor is having a brief look at a fund’s risk, it can be limited in its use.
“Tracking error should be used with other factors like maximum drawdown, Sortino ratios, information ratios etc. These can all tell a different story so it makes sense to look at various factors when analysing data on funds,” she said.
