While gains or losses of the broader equity markets ultimately drive returns of equity funds, the component of active management can also make a difference to an investor’s returns. The majority of funds on our platform are actively-managed funds, where the fund manager makes specific investment decisions with the aim of outperforming a benchmark (like Singapore equity funds trying to outperform the FTSE STI).
The extent to which a fund’s performance deviates from its benchmark is often referred to by the investment community as “active risk” or “tracking error”, terms which seem to carry negative connotations - this is simply a result of modern portfolio theory’s definition of the market (ie. the benchmark) having only “market risk”, so by deviating from the market, an investor is thus being exposed to additional investment risk.
While there are those who prefer to have less “active risk” in their investments, it is also logical that managers who deviate more from the benchmark can offer investors a better chance at obtaining stronger investment returns, which may appeal to some investors. In this article, we run a simplified quantitative “tracking error” screening of several popular categories of funds on the platform, highlighting some which appear to be more actively-managed, and others which have less tracking error.
METHODOLOGY
Our screening process utilised monthly returns (in SGD) for the funds compared against that of the benchmark, and calculated over 3-year and 5-year periods which ended in August 2012. The formula used was the “root mean square” of active returns (defined in our case as the difference in monthly returns, whether positive or negative), while we also used the same benchmark across each category – while this approach disregards the subtle “style” differences in benchmarks for different funds, it allows for a fairer peer-to-peer comparison. In addition, we also omitted funds which are principally invested in specific sectors, or small/mid-cap stocks.
RESULTS
| Table 1: Average Tracking Error by Category | |||||||||||||||||||||||||||||||||||||||||
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| Source: iFAST compilations, as of end-August 2012 | |||||||||||||||||||||||||||||||||||||||||
Among the 9 categories of equity funds we examined, funds invested in the US, Asia, and China had some of the highest tracking error figures over a 5-year period, while Japan and Singapore equity funds had the lowest. With the exception of Asia Pacific ex-Japan equity funds, the trend was fairly consistent over 3 years as well. That US equity funds posted the highest tracking error amongst the various equity fund categories is somewhat surprising, since the US equity market is often viewed as one of the most efficient in the world, which would be an argument for US managers to take a more passive approach; our data appears to suggest otherwise. We now take a closer look at some of the categories to highlight funds which have demonstrated larger or smaller deviations vis-à-vis the benchmark, an indication of how actively managed the strategy is.
Full article here: FSM
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