Question

Fund A which is an active long-only fund and Fund B which is an absolute return fund. They are both restricted to investing in the US equity market, but have the flexibility to buy individual securities and use derivatives. The benchmark market return for the period was 10% and the risk-free rate was 2%. The performance data for the two funds over the same period is shown in the table below.

	Fund A	Fund B
Total Return (before fees) %	11.2	3.9
Volatility %	16.3	6.1
Tracking error %	7.2
Beta	1.0	0.3

1. Briefly explain the term ‘absolute return’ strategy.
2. Calculate the information ratio for Fund A and discuss whether, on this basis, it has generated a good performance.
3. Which of the fund managers appears to be exhibiting better stock picking skills?
4. Comment on the tracking error of 7.2% in Fund A. Why is there no tracking error number given for Fund B?
5. The manager of Fund A is a manager with a growth style of investing. Explain the philosophy behind growth investing.

Answer 1

a) The absolute return strategy is based on the premise that such funds will earn a positive return over time, regardless of the market going up, down, or sideways. They do not have a set benchmark, as against other funds which might have a stock index as a benchmark to assess the performance of the fund. Such strategy funds have a low correlation with market returns. Absolute return strategy funds aim to achieve this goal by investing in various diverse asset classes.

b) The information ratio measures the returns of the portfolio generated over and above a set benchmark, with respect to the volatility of the excess returns generated. The benchmark here is generally the market index.

Information ratio = (R(p) - R(b)) / Tracking error

R(p) = rate of return on the portfolio

R(b) = Benchmark rate of return

Information ratio for Fund A = (0.112-0.1)/0.072 = 16.66%

The information ratio of 16.66% is considered to be average. An information ratio of above 30% is considered to be quite good and above 50%, it is considered as extremely good performance. Higher the ratio, better is the performance.

c) We look at Jensen's alpha to judge the stock-picking skills

Jensen's Alpha = R(p) - ( R(f) +Beta*(R(m)-R(f)))

Jensen's Alpha of Fund A = 0.112 - (0.02+1*(0.1-0.02)) = 1.2%

Jensen's Alpha of Fund A =  0.039 - (0.02+0.3*(0.1-0.02)) = -0.5%

Since fund A has higher Jensen;s alpha, its fund managers appears to be exhibiting better stock picking skills

d) Tracking error is the divergence of the portfolio performance from the performance of the benchmark index. Fund A's tracking error of 7.2% signifies that the returns of fund A with respect to the index has a standard deviation of 7.2%. Higher tracking error must be compensated by higher returns.

Fund B is an absolute return strategy fund. Such funds intends to generate a positive alpha, irrespective of the market returns. Also, the return on these funds is not set against any benchmark index and hence there is no tracking error for Fund B as its performance is not measured against any benchmark.

e. The tracking error of Manager A is high at 7.2%. This means that the manager is taking on additional risks to generate a higher Jensen's alpha, as seen in part c. Manager A invests in growth stocks, even though if it means taking a slightly higher risk than the average market portfolio. Hence, the manager of Fund A is a manager with a growth style of investing.