This ratio can safeguard your portfolio

The challenge in selecting actively managed equity funds is not so much the lack of alpha as the variability and rotation in winning managers generating alpha from time to time. It is more the fact that someone new is at the top of the alpha league tables every other year, and there is a lack of consistency in the alpha generation.

Having such wild winner rotation in the alpha league tables, with rarely anyone sustaining alpha generation, is as good as not having alpha from an investor and investment selector's perspective. The least it does is make the process of fund selection very hard and sticking to selected funds even harder.

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, only half the batsmen score above average, and in every game, a different set of batsmen beat their average.

How do you pick a team? The bench looks very strong; the team management believes we have the right talent but is unable to create a winning team. What is the use unless there is consistency? You are much better off having a bench with a lower average but high consistency. You can still drown in a river with an average depth of five feet. This analogy underscores the importance of understanding consistency over mere averages. In investment terms, just because a manager has a high average alpha, it doesn't mean they are reliable contributors to a portfolio's success.

The information ratio addresses this very concern for investors, offering a sophisticated tool that emphasises 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, alpha is divided by the standard deviation or measure of the variability of alpha; it tells investors how much additional return they are receiving for the extra risk taken by deviating from the benchmark.

Going back to the cricketing example, player A has a batting average of 45 runs and generally scores between 20 and 70 runs. Player B has a batting average of 48 runs and could score anywhere between 0 and 150 runs. What kind of players do you want to populate the team with? How much will you stake on player A vs player B in a crunch situation when you have to send one of them to bat in the crucial overs?

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. We don't need the highest alpha if it comes with high variability, i.e., huge positives followed by huge negatives. What we need is a consistent alpha with low variability.

Fund management is not just stock picking; portfolio construction is equally important for good investor experience. Sometimes, one can drown in a river that is five feet deep; it's not the average alpha that matters, it's the variability between the shallow and the deep that matters.

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 or what currently is "hot" or "trending" in markets.

When the macroeconomic environment changes, what works in markets changes and what works within the benchmarks also changes. This would often result in the manager with the 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 a consistent performer, someone with above-average alpha but low variability; someone who is in the top quartile when portfolio positions or investing preferences are aligned with market conditions and bottom of the second quartile or top of the third quartile when portfolio positions or preferences in investing are not aligned with market conditions.

Picking funds with a healthy information ratio ensures investors are not exposed to extremes of performance; they get consistent experience and can stay put for longer to enable compounding of investment.

Aashish P Somaiyaa spearheads WhiteOak Capital Asset Management Limited as their CEO.

Also read: One more asset allocation tip