Since 1970, a series of academic articles have promoted the development of improving the success rate of active investment. In the past few articles, we have compared passive and active investments. For the supporters of active investing, how to apply the concept of active management to investment? More importantly, how can improve the return on active investment? This article will interpret the questions for readers.
The information ratio determines the value of an active investment
For the average investor, active investing means picking an investment manager or product that can beat the benchmark index. For investment managers, aim for a higher ratio of additional returns to risks. In technical terms, this is the information ratio. By splitting the information ratio of different periods, investors can further measure the stability of the excess return of investment managers and products. Blackrock has measured the performance of active management of different us equity and bond funds between 2003 and 2007. The median information ratio is 0.12, reflecting the ability of more than half of its products to add value.
Investment managers and products with higher information ratios are more attractive. Should investors put all their money into products with past information ratios? The answer is clearly no. On the one hand, different investors have their own risk appetite. When the risk taken by the investment exceeds the turning point, the marginal utility will decline or even become negative. Therefore, investors’ risk budget needs to be considered in the management of active investment. On the other hand, the information ratio is only the expected value of the investment manager and the active management of the product, rather than the actual return. The distribution of information ratios derived from historical data does not guarantee future returns.
Sources of additional revenue
The extra benefit usually comes from the difference between actual results and market expectations. Stocks, for example, react when the results of earnings announcements differ from market expectations. The more the managers’ expectations match the actual results, the more their products will earn excess returns. What is more, what is also efficient is the information coefficient that is what allows each prediction to be relevant to the reality.
Additional earnings may also be affected by fluctuations in forecast results. Utilities, for example, have a more stable outlook for future cash flows. On the contrary, most technology companies are in their infancy, more relevant to the economic cycle and more volatile. Tech stocks are more likely to generate excess returns than utilities, but they also face higher risks. Therefore, the information coefficient reflects the investment ability is the core of the source of additional income.
The impact investment breadth and cost
Increasing the investment breadth also increases the information ratio. However, breadth is often misunderstood by investors, who believe that more markets and products can increase the value of active investment. Only adjustments based on new information can create new forecasts. The more forecasts, the better they reflect the investment manager’s ability to rule out individual events. Due to the limited time and energy of people, the higher the investment scope is, the better. It is more important to maintain the investment ability. Of course, the impact of cost cannot be ignored.