We use the information ratio to spot investment products that have consistently done well.
Thursday 17 May 2018 Author: Daniel Coatsworth

One of the best ways to pick funds is to look at the long-term track record and to see how a product has performed through different economic cycles.

You should try and find out if a fund has been able to deliver again and again, and hasn’t merely had a few spectacular years to help lift the long-term average figure.

A good way to help filter the market is to use something called ‘the information ratio’. This is a measure of consistency in outperformance.

‘The information ratio is an interesting way of looking at fund manager returns as it indicates whether a manager is being rewarded for investing away from the benchmark,’ explains Ryan Hughes, head of active portfolios at AJ Bell.

‘Put another way, it is an assessment as to whether the active bets in the portfolio have paid off.’

Hughes says it can be a good way of separating two funds that have similar absolute performance but which have been achieved in very different ways.

‘While it is possible to be lucky over the short term, those fund managers that can have a good information ratio over the long term arguably have been able to evidence skill in stock selection as it is far harder to be lucky over long periods.’

HOW DO YOU KNOW IF A RATIO IS GOOD OR BAD?

In a nutshell, an information ratio above 0.5 is considered to be good. A figure above 1.0 is considered to be excellent.

Our research finds that 13 funds have scored above 1.0 based on the past 10 years; and 78 funds score above 0.5 over the same time period.

We acknowledge the information is based on past performance which isn’t always a guide to future performance. However, the ratio can be a useful tool as part of your wider investment research process.

Later in this article we’ll look at 10 collectives that have superior information ratio scores based on data for the past 10 years. They’ve all achieved an information ratio in excess of 1.0.

The list of funds includes some well-known products such as LF Lindsell Train UK Equity Acc (GB00B18B9X76) as well as other funds such as BlackRock European Dynamic D Acc (GB00B5W2QB11) and Liontrust Special Situations I Inc (GB00B57H4F11).

WE’VE HAD THE PROS….  WHAT ABOUT THE CONS?

Before we profile the 10 funds, it is important to understand the potential downsides of using the information ratio.

‘Investors should be aware that the information ratio is highly dependent on the time period under measurement and the chosen benchmark index,’ wrote Deborah Kidd from Boyd Watterson Asset Management in 2011.

For example, research by Thomas Goodwin in 2009 found that managers benchmarked against the S&P 500 index as a proxy for the market had lower information ratios than those benchmarked against the Russell 1000 Index. The latter is a much broader index than the S&P 500 although both are considered to be large cap stock benchmarks.

Similarly, managers who used the Russell 2500 index as a proxy for the small-cap universe had notably poorer information ratios than managers measured against the Russell 2000.

‘Favourable information ratios can be generated by manipulating the measurement period to include or exclude certain performance periods,’ said Kidd.

‘Market conditions during the time period under evaluation should also be considered. Were market returns dominated by a value or growth style or by cap size? Does the investor believe the style – and the manager’s strategy in relation to it – will continue?’

HAVE THERE BEEN ANY CHANGES?

Another point to consider when using the information ratio to find superior funds is whether a fund’s strategy has changed during the period under review, or indeed the fund manager.

‘While it is a good method of identifying consistency, especially when used over a long period, not all fund managers are able to deliver consistent performance,’ comments Hughes at AJ Bell.

‘Some managers have a strong investment style which will come in and out of favour. We expect such managers to have periods of underperformance and outperformance but when their style is in favour, we expect them to outperform strongly. This return profile is not conducive to having a good information ratio but it doesn’t make these managers bad fund managers.’

Hughes says those managers who have an excellent information ratio in the data for this article have clearly been able to deliver consistently good performance over a long period of time but it won’t make them suitable investments for everybody.

‘That said; managers such as Anthony Cross at Liontrust, Nick Train at Lindsell Train or Alister Hibbert at BlackRock (whose funds appear on Shares’ list in this article) are clearly talented fund managers who have stood the test of time over very differing market conditions.

‘Their work is to be commended and they are quite rightly lauded as some of the best in the business. The information ratio is an excellent method of identifying these characteristics.’


How does the information ratio differ to the Sharpe ratio?

The information ratio is a risk-adjusted performance measure. It is a special version of the Sharpe Ratio. It differs in the sense that the benchmark doesn’t have to be the risk-free rate.

The Sharpe ratio is calculated using standard deviation and excess return to determine reward per unit of risk.


Stewart Investors Asia Pacific Sustainability B GBP Acc (GB00B0TY6V50)

This fund invests in Asia Pacific-focused companies which are positioned to benefit from, and contribute to, the sustainable development of the countries in which they operate.

Fund manager David Gait launched the fund in 2005 and still runs it today. It has achieved 248.1% return in the 10 years to 31 March 2018, nearly double that of its benchmark (133.6%).

‘The portfolio will often have a high active share relative to its MSCI AC Asia Pacific ex Japan benchmark, and the biases inherent in the strategy lead to a performance profile that can differ significantly from its peers,’ says Morningstar analyst Simon Dorricott.

‘It typically loses less than peers in down markets, although it can lag in certain market conditions such as low-quality or cyclical rallies.

‘We continue to have faith in the consistently applied investment process and in the experienced manager and relatively stable sub-team who implement it.’

It aims to maintain a portfolio of between 60 and 80 individual stocks in which the fund manager has high conviction.

The bad news for individuals not already invested in the fund is that Stewart Investors has imposed measures to deter new money flowing into its product as it wants to avoid the fund getting too big.

Although you can still invest in the fund, you’re faced with an initial 4% charge imposed by the asset manager.

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Fidelity UK Smaller Companies W Acc (GB00B7VNMB18)

Fund manager Alex Wright has looked after the Fidelity UK Smaller Companies Fund since its launch in February 2008 and is highly rated as a small cap stock picker. However, Jonathan Winton has co-managed the fund since 2013 and has become increasingly influential with stock selection and portfolio construction.

‘The portfolio is built from the bottom up and continues to follow a well-defined process,’ says Morningstar analyst Simon Dorricott. ‘The manager seeks stocks that offer strong downside protection with unrecognised growth potential, which will include internal and/or external change.

‘He looks to buy into such situations at an early stage, ideally before any recognition of a change in fortunes. These positions are then held as operational change comes through and market perception improves, resulting in a portfolio of holdings demonstrating different characteristics.’

Matthew Jennings, investment director at Fidelity International, says the fund’s performance can largely be attributed to the ‘bottom up’ stock picking skills of Wright and Winton, ‘focusing on unloved and undervalued stocks where they believe the market has overlooked the potential for recovery’.

Like the aforementioned Stewart Investors product, Fidelity UK Smaller Companies is another soft-closed fund. However, we note that AJ Bell Youinvest has an agreement with the asset manager so that it is still able to accept investments in the fund without any initial charge that usually comes with soft-closed products.

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Liontrust Special Situations I Inc (GB00B57H4F11)

This fund is managed by Anthony Cross and Julian Fosh and is very particular about the type of companies that it holds. Cross explains that companies must have ‘certain intangible assets’ including intellectual property, trade secrets ‘know how’ and large scale distribution networks.

The point of these attributes is that they are hard to copy, thus giving these companies high barriers to competition. In terms of companies with large distribution networks, Cross cites drinks company Diageo (DGE) and consumer staples company Unilever (ULVR).

‘We also like data driven distribution networks that you find in Rightmove (RMV). Fidessa (FDSA), or market research businesses like YouGov (YOU:AIM). Data is within their clients so difficult for others to get at and replace,’ says Cross.

The fund has a low portfolio turnover which Cross explains is often driven by takeovers – as evident by Fidessa and fellow holding Shire both in bid situations.

Another must for the manager is recurring revenue, targeting companies with at least 70% of income coming from established sources.

While the fund can invest in companies of any size, Cross reveals that it has around 30% of its portfolio in small caps. He says the team has a lot of small cap experience and if they find a great small company and let it compound for 10 years, investors can receive ‘lovely returns’. Companies the team avoid include cyclical stocks such as housebuilders and banks.

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BlackRock European Dynamic D Acc (GB00B5W2QB11)

Given the resources of the world’s largest asset manager BlackRock, its fund managers can be assured of having a well-resourced team supporting them.

Run by Alister Hibbert, BlackRock European Dynamic seeks mispriced companies through rigorous bottom-up fundamental research.

Crucial for stock selection is finding companies which have potential share price drivers that the market has yet to appreciate. For example, this could involve spotting companies which have stronger earnings potential than the market is anticipating.

Given the Europe ex-UK region is a favourite for fund managers at the moment amid reasonable valuations and decent growth indicators, there is a lot of competition to find different companies to those owned by rival funds. But its focus on both growth and value stocks seems to be paying when looking at its superior performance.

The portfolio currently includes stakes in aerospace group Airbus and German car-parts maker Continental.

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Royal London UK Equity Income M Inc (GB00B3M9JJ78)

Run by the highly experienced Martin Cholwill, this fund invests in the type of companies often expected in a UK equity income fund such as Royal Dutch Shell (RDSB), HSBC (HSBA) and BP (BP.). It also has a selection of smaller companies which are believed to become consistent dividend payers at some point.

Cholwill has a big focus on free cash flow when choosing his holdings and for a fund targeting almost 4% yield this seems a sensible metric to use. He believes that accounting earnings can be manipulated whereas cash is more tangible and that it is cash that pays the dividend and something immune from any ‘creative’ accounting.

For this reason, Cholwill’s use of broker research is quite selective as these tend to focus on accounting earnings rather than cash flow and his main concern is for a company’s ability to maintain and grow its dividend.

Given the dividend focus, the fund’s exposure to small caps is limited as many companies down the bottom of the market cap spectrum are unlikely to pay dividends. Around half of the fund’s holdings are FTSE 100 companies although given the position sizes are based on conviction, the fund’s sector allocation can look very different from the index itself.

Part of the reason for having a conviction-led approach is that Cholwill is aware that the majority of dividends are generated by a small group of mega caps so he uses this technique to avoid over-concentration in those names.

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LF Lindsell Train UK Equity Acc (GB00B18B9X76)

This is perhaps one of the best known products in the UK funds universe, thanks to fund manager Nick Train’s great reputation. It invests primarily in UK company shares and has a concentrated portfolio with low turnover. Train has run the fund since launch in 2006 but has been a well-known figure in the industry for longer thanks to his involvement in another fund called Finsbury Growth & Income (FGT).

‘Train’s process is differentiated and has proved successful across a variety of market conditions. He looks for unique and high-quality companies that offer a high and sustainable return on equity, show low capital intensity, and are cash-generative,’ says Dorricott at Morningstar.

‘This remains amongst our highest-conviction funds because of its experienced manager, well-defined and consistently applied investment approach, and competitive fee structure.’

Current holdings in the fund’s portfolio include consumer goods group Unilever, drinks giant Diageo, information and analytics firm RELX (REL) and investment platform provider Hargreaves Lansdown (HL.).

In April, Train said that companies representing 5.5% of his portfolio have received takeover bids that look likely to succeed, meaning he could get a large chunk of cash in the near future to either add new names to the portfolio or buy more of existing ones.

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Baillie Gifford Japanese B Acc (GB0006011133)

Similar to the aforementioned Liontrust product, this fund from Baillie Gifford looks for companies with low levels of competition that are also durable and growing.

The fund also holds young companies capable of double-digit growth rates that can be sustained for years to come.

Alex Blake, client manager at Baillie Gifford, says: ‘The market’s preoccupation with short-term trends and themes generates exploitable opportunities for patient, bottom-up investors, not least because there is a persistent tendency for the market to undervalue sustainable earnings and cash flow growth.’

Baillie Gifford is happy to hold cyclical stocks with its largest holding being Softcorp Bank.

The fund also likes companies in turnaround mode; those that look to be struggling but are putting through structural change to benefit the company in the long term.

The portfolio of between 45 and 60 stocks are chosen with little regard to the companies’ importance to the index.

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Man GLG Continental European Growth C Professional (GB00B0119487)

Fund manager Rory Powe has invested in European stocks for more than 25 years including long periods at Powe Capital and Invesco before joining Man GLG in 2014.

The Man GLG European fund is reasonably concentrated, aiming for between 30 and 40 holdings. It takes a long-term approach and likes to invest in Europe’s strongest companies. As a result, you’ll see some holdings that have strong market positions such as airline Ryanair (RYA) and car maker Ferrari.

He likes companies with a sustainable competitive advantage and where they can raise prices without having a negative impact on consumer demand. He also like companies which can benefit from scale as they expand. Naturally these companies have to be financially strong and trading on a reasonable valuation at the time of investment.

Powe has proven to be exceedingly good at his job based on past performance figures, so we believe it is worth having his fund in your portfolio in order to benefit from exposure to Europe.

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Invesco Perpetual Global Smaller Companies Z Acc (GB00B8N46D97)

Launched in 1984, this fund invests in smaller companies around the world. Smaller companies have historically outperformed large caps although they have also been a higher risk area in which to invest.

According to data at the end of March 2018, nearly 30% of the Invesco fund’s portfolio contained US-listed stocks, circa 13.5% Japanese-listed stocks and just over 11% UK-listed stocks, among other geographical exposures.

You may be unfamiliar with most of the names in its top holdings apart from Hyundai Motor, Samsonite and Philips Lighting. The portfolio currently has 380 holdings so risk is spread quite widely.

We note there has been a change in fund manager over the past 10 years with current lead manager Nick Mustoe only having run the fund since July 2015. He is helped by Juan Hartsfield who started a year later on the fund.

However, these two individuals have considerable help from colleagues at Invesco. Strictly speaking, the fund is managed by Invesco’s ‘Global Smaller Companies Group’ which contains many different fund managers, product and investment strategists, with Mustoe chairing this group (as well as being Invesco’s overall chief investment officer). The fund managers also tap into the investment resources of their own regional teams.

Decisions are taken with a long-term perspective which inevitably means the portfolio turnover is kept low.

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Royal London UK Mid-Cap Growth M Acc (GB00B5BRW420)

Managed by Henry Lowson, the fund seeks to achieve capital growth over the medium to long term by investing in mid cap companies.

Its top holdings include some solid mid-market names including Dechra Pharmaceuticals (DPH) and BBA Aviation (BBA).

Lowson’s approach is to choose companies which he believes can grow their profits and cash faster than the market and ultimately become large cap companies. He seeks companies where all the good news is not reflected in the share price and where there is potential upside to valuation ratings and analyst expectations for earnings.

The fund manager looks at the industry in which a company operates and then analyses its place in the sector. His checklist includes quality of management, pricing power and strength of the balance sheet. He will visit companies to facilitate idea generation.

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