We shall be using the terms ‘top’, ‘bottom’, ‘best’ and ‘worst’. These words should not be taken to mean that there is anything intrinsically good or bad about the funds about which we use such terms; they are meant to describe how well or otherwise they fit the criteria we have selected. Where there is an evident reason for the degree of fit, we shall point it up in the text.
Methodology
The methodology used to determine the ‘Top’ and ‘Bottom’ funds will differ for each sector, depending on the predominant aim of the sector. For example, the volatility element would be of much greater significance when looking at the IMA Cautious Managed sector than when looking at Global Emerging Markets.
The criteria used for the determining the ‘Top’ and ‘Bottom’ funds in the IMA Active Managed sector are:
· Crown Ratings (Crown Ratings are assigned after measuring three factors: performance, volatility and consistency. The highest rating is three crowns)
· R-squared
· Performance over 36 months
· Information Ratio
· Sharpe Ratio
· Quartile over both 1 year and 3 years
· Volatility
Using these criteria it is possible to get preliminary lists of the best and worst funds in the sector. These initial lists, usually containing about 10 funds each, are analysed to reach the final five in each category. We can now turn to the first of our tables and the analytical commentary.
IMA Active Managed sector
| Top 5 funds | Crown Rating | quartile over 1 year | quartile over 3 years | r-squared | Info Ratio | Sharpe | annualised Volatility | 36 month bid-bid performance | Value of £1000 invested 3yrs ago |
|---|---|---|---|---|---|---|---|---|---|
| M&G UK - Managed Growth | 3 |
1 | 1 | 0.91 | 1.7 | 1.72 | 11.03 | 85.8 | 1857.95 |
| Neptune Investment Mgmt - Global Alpha | 3 |
1 | 1 | 0.75 | 1.68 | 1.87 | 15.15 | 137.24 | 2372.43 |
| Newton Investment Managers - Acer | 3 |
1 | 1 | 0.91 | 0.99 | 1.77 | 8.12 | 65.84 | 1658.35 |
| Newton Investment Managers - Ilex - | 3 |
1 | 1 | 0.91 | 1.09 | 1.73 | 8.58 | 67.73 | 1677.33 |
| Prudential UT Mgrs - Growth | 3 |
1 | 1 | 0.91 | 1.71 | 1.74 | 11.07 | 85.91 | 1859.06 |
Analytical Commentary
A number of distinctive characteristics define the essential nature of this sector, and thus our expectations of the funds within it. We can expect annual management charges (AMC) to be higher for actively-managed funds than those levied on, say, index trackers. Given the implicit investment approach, it would be no surprise to encounter raised levels of risk, either. What we can say also is that, in return, investors are entitled to expect proportionately higher rewards. And if a fund can deliver these while reining in the risk side of the equation, then, in our assessment, this combination will set the fund above those with similarly superior returns, but which offer a rockier ride.
As it pans out, three of our top five funds also take the top slots in the sector performance table as a whole. Neptune, Prudential and M&G have posted returns that exceed the sector average by 83.1%, 31.8% and 31.7% respectively. The two Newton funds also turn in respectable outperformance and, as we shall see, they make the cut because of their restrained volatility.
Volatility across our selected funds is tidily progressive, with the risk measure increasing as the level of return mounts. Thus we see Newton’s funds clustering tightly around the sector’s average of 8.57%, in combination with gains that do not hit the headlines in this company, but nonetheless will not have disappointed their investors. As we move up the performance table the risk factor increases commensurately, and by studying other performance ratios we can gain an insight into how the assumption of greater volatility has been rewarded.
Sharpe Ratio acts as a broad indicator: it starts with the fund’s return, deducts what could have been earned from a notional risk-free deposit (in our example, 3.5%), then divides the result by the fund’s volatility. In this way, we end up with the amount of return generated for each unit of risk in the portfolio, and we move closer to the kind of test that we want to apply in this sector.
All of our top 5 funds display healthy, positive Sharpe, so their volatility is generally paying off. It is notable that the two Newton funds punch above their weight on this measure, with Sharpe standing up strongly against their peers. Here we can see the influence of volatility, in that Ilex produced the higher return, while Acer’s higher Sharpe is a product of its lower volatility. But we can also see that volatility will not hold a fund back when it is related to investments that have produced disproportionately generous returns. On Sharpe, Neptune’s Global Alpha heads the table despite having the highest risk factor, due to its substantially superior gains.
So far, so good; but, by definition, with this kind of fund we want to see evidence of an active intelligence producing returns in excess of what a more pedestrian fund would yield, and earning those higher AMCs. To gauge this, we’ve subjected our group to the more stringent test that is the Information Ratio (IR). Like Sharpe, this calculation deducts a notional risk-free rate from the fund’s return; but, further, it also discounts the benchmark return that would have resulted – without the manager’s intervention - from market movements. The resulting (hopefully) excess return is then divided by the volatility that attaches to it, to give us the amount of excess return that has been generated per unit of excess risk.
By using the unblinking IR as one of our key yardsticks we put managers on their mettle, and distinguish those that are successfully using active management skills from those that either are making unprofitable bets, or are sitting back and letting the benchmark do the job. Conventionally, an Information Ratio between 0.5 and 1.0 is seen as a very good performance, and even the lowest two IRs in our group achieve this distinction. But it is our top three which can again claim the laurels: IRs in a range that starts at 1.68 are evidence of a superb degree of stock-picking ability which is amply rewarding the risk taken on. On this measure, M&G pips the others at the post, but it has to be said that it is Neptune’s Global Alpha that looks like the star overall.
It is a different story with the funds that we have assessed as the worst in our selection, and we shall now examine our second table of results.
| Bottom 5 funds | Crown Rating | quartile over 1 year | quartile over 3 years | r-squared | Info Ratio | Sharpe | annualised Volatility | 36 month bid-bid performance | Value of £1000 invested 3yrs ago |
|---|---|---|---|---|---|---|---|---|---|
| Capita Financial Managers - Balanced Growth | 1 | 4 | 4 | 0.73 | -0.59 | 0.73 | 10.77 | 39.95 | 1399.53 |
| Capita Financial Managers - Global Equity GDIF | 1 | 4 | 4 | 0.78 | -0.74 | 0.71 | 10.51 | 36.65 | 1366.46 |
| CF Ruffer Investment Mgmt - Equity & General | 1 | 4 | 4 | 0.42 | -0.71 | 0.59 | 9.35 | 26.53 | 1265.29 |
| Kleinwort Benson UT Mgrs - CF Amadeus | 1 | 4 | 4 | 0.76 | -0.72 | 0.92 | 8.62 | 45.26 | 1452.59 |
| Legal & General - (Bclys) Advtur Gth | 1 | 4 | 4 | 0.92 | -0.86 | 0.94 | 9.46 | 43.61 | 1436.14 |
The single Crowns – the lowest designation in Financial Express’s ratings system – provide an early indication that all is not rosy in the garden. Based on quantitative analysis, Crown ratings measure a combination of three elements in the funds’ histories: performance (as evidenced by Alpha), volatility, and consistency. A significant deficiency in any one of these areas can reduce a fund’s rating, as can lacklustre performance across the board.
In headline terms, all five funds have underperformed the sector average return of 54%. But while a conscious decision to operate at the fourth quartile level could reasonably be expected to be aimed at reducing risk, it has not – volatility statistics in this group are not markedly different from those in 4 of our top 5 funds. It is fair to say that these poorer outcomes would not have come about by design.
There may be some investors who are not dissatisfied with the levels of return from these funds, but it would require comparison with the lower returns from entirely different areas of the market to arrive at this view. Yes, we do have positive Sharpe ratios, despite the drag effect of volatility. But in this sector this is insufficient cause for consoling oneself with the thought that that’s alright then.
Let us come to the main point at issue: active management. With negative Information Ratios, each of these funds has taken on risk in excess of that of the underlying sector, and for each unit of that additional volatility, losses were incurred. In effect, the management of these portfolios has added to their overall risk, and/or eaten into the return that could have resulted from tracking the sector. As we have said, no manager will have sought these results deliberately, and we are left with a question about the skill that was deployed in pursuing an outcome the opposite of which has materialised.
In the final analysis, if a degree of riskiness is to be expected in an actively-managed sector, this is no reason for us to assess the sector’s constituents in ignorance of volatility’s impact on the risk/reward relationship within their portfolios; in other words, we should not select one fund’s return record over another’s without judging the manager’s ability either to restrain risk or to be well rewarded for it.