Wealth through Investing

Skill Ratio vs. Information Ratio


Following the introduction of the Skill Ratio, it’s worth exploring how it differs from the information ratio.

First, how are they calculated? The information ratio’s denominator can be computed in different ways, but it generally explores tracking error based on shorter time periods, usually monthly or annually. The Skill Ratio can also use varying time periods, but the original article applied a “tracking error” based on rolling five-year returns.

The distinction is this: As an investor, I should be willing to forgive a manager who has a bad month or even a bad year. I want to give a portfolio manager the benefit of the doubt and allow proper time for their investment theses to play out. Demanding consistent outperformance over such short time periods is unrealistic. Therefore, it is inappropriate to judge excess returns on a monthly or even annual basis.

What I have a much harder time overlooking is a bad five-year period.

Might five years seem arbitrary or even too short? Perhaps. But it doesn’t matter if an active manager can eventually outperform over a “full market cycle” or within seven years instead of five. Why should I wait an entire market cycle or seven years for an active manager when the Skill Ratio shows that there are cheaper options — multi-factor indexes — that have consistently delivered outperformance within a five-year window?

I’m not out to prove that active management doesn’t work, just that a more logical solution exists for those who wish to pursue alpha. I don’t have to outrun the bear, I just have to outrun you.

When comparing the information ratio and the Skill Ratio across all 490 US large-cap funds that have survived since 1999, there is an Rvalue of 0.70. This indicates some degree of significance in the relationship between the information ratio (independent variable) and the Skill Ratio (dependent variable).

US Large-Cap Mutual Funds, 1999–2017

US Large-Cap Mutual Funds, 1999–2017

However, when you cluster the data into funds that outperformed and underperformed the S&P 500, a different story unfolds.

Funds That Underperformed the S&P 500, 1999–2017

Funds That Underperformed the S&P 500, 1999–2017

The Rvalue for underperformers shows a relatively high correlation (0.65) between the Skill Ratio and the information ratio.

Ultimately though, the Skill Ratio, like the information ratio, is intended to be used with managers who have delivered some level of outperformance over time. Whether or not it’s sensible, most people can, and do, rule out underperforming investments based simply on their lagging returns. No pompous ratio is necessary.

However, among the cluster of outperformers, the Rvalue is 0.39, which does not indicate a convincingly strong relationship between the Skill Ratio and the information ratio.

Funds That Outperformed the S&P 500, 1999–2017

Funds That Outperformed the S&P 500, 1999–2017

One of the two data points near the top of the preceding graph is the Natixis US Equity Opportunities, which has an information ratio of 0.32 and a Skill Ratio of 1.78. The large residual indicates that the fund had relatively volatile excess returns on a monthly basis but fairly consistent excess returns on a rolling five-year basis.

Isn’t it worthwhile to understand that while a manager’s monthly excess returns may be volatile, their excess returns across five-year time periods are relatively smooth?

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/erhui1979

Daniel Blais, CFA

Daniel Blais, CFA, began his career at BlackRock where he spent five years as an iShares consultant and strategist. He currently works at a global family office in Miami. In addition to his CFA charter, he holds a BA in finance from the University of Notre Dame.


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