We’ve discussed how active managers can strive to minimize the impact of luck on investment decisions. But how can managers generate skill, and can they do so with sufficient quantity and sufficient discipline to potentially deliver positive results for investors?  Here, a simplified look at a factor called the Information Ratio may be instructive. The information ratio is an indication of the productivity of a manager in adding value to investment decisions; the higher the IR, the better. The IR basically comes from 1) the level of skill, and 2) how often that skill is put to use.

Skill:  As we’ve said, active management requires the existence of market inefficiencies, but managers must have the ability to both identify, and capitalize upon, these inefficiencies.  Academically, this ability to spot a market mispricing or inefficiency is known as an Information Coefficient—colloquially, “manager skill.” A positive Information Coefficient means that a manager is able to identify and monetize such inefficiencies at a rate above pure randomness through some form of information advantage.

Breadth:  The second part is equally important: repeating the process enough times to improve the potential statistical edge of manager skill. An effective or skilled active manager can help to navigate a universe of imperfect knowledge, and the vagaries of chance, by having a sufficient number of decisions to minimize the impact of luck and cause their outcome over time to more closely resemble their overall skill. Multiple decisions in a portfolio is critical in allowing investment expertise to rise above the element of randomness.

The Importance of Relative Value

The Importance of Relative Value

Thinking about how various inputs affect security valuations can be quite complicated when it comes to assessing large macro factors, such as the direction of interest rates, credit spreads, economic factors, broad market multiples, etc. This assessment is further complicated by the way in which a change in one variable may impact others, which, when considering the intricacies of macroeconomics, may lead to any number of macro outcomes.

The fewer the variables an analyst has to consider, therefore, the more likely that their identification of information mispricing will have the expected result.  Relative value assessments, which require only the identification of pricing differentials across similar assets, can simplify this analysis.  They allow an investor to isolate a few key variables, potentially increasing the efficiency of whatever information advantage they might have, and ideally reducing the role of luck in the outcome.