BAFI6010 · Advanced Investment Management
Mutual Fund Analysis (Part 1)
Topic 8 turns the performance-measure and attribution toolkit from earlier in BAFI 6010 loose on real US mutual funds (from LSEG/Refinitiv and Morningstar data) to answer one practical question: which manager deserves an active fee, and which is a closet indexer? Part 1 is the quantitative screen — risk-adjusted ratios (Sharpe, Treynor, information ratio), alpha/beta/R², capture ratios and drawdown, plus Active Share and quartile/peer ranking. The recurring exam skill is judgement: rank funds on risk-adjusted, net-of-fee numbers and pick the reliable, cheaper manager — not the biggest headline alpha.
What this chapter covers
- 011. Applying the toolkit — Topic-7 measures (alpha, beta, R², ratios, drawdown) run on real funds
- 022. Absolute vs relative measures — Sharpe/SD/VaR/drawdown vs beta/R²/tracking error/information ratio
- 033. Alpha, beta and the tracking-error band — alpha = SML intercept, TE = scatter around the line
- 044. Information ratio — IR = alpha ÷ tracking error, the single best measure of active skill
- 055. Active Share = ½ Σ |w_Fund,i − w_BM,i| — how active a portfolio is (evidence as predictor is MIXED)
- 066. Capture ratios & R² — want >100 upside / <100 downside; high R² flags an index-like fund
- 077. Quartile & percentile peer ranking — Q1 = top 25%; low percentile = good; consistency across horizons
- 088. Active vs passive — pay only for significant, net-of-fee alpha; spot the closet indexer
Selecting a fund on risk-adjusted ratios and alpha reliability
- +1Sharpe = (r̄ − rf) / σ: A = 11.2/14.0 = 0.80; B = 9.6/12.0 = 0.80 — a dead tie.
- +1Treynor = (r̄ − rf) / β: A = 11.2/1.00 = 11.2; B = 9.6/0.80 = 12.0 — B marginally higher.
- +1Information ratio = alpha / TE: A = 1.5/3 = 0.50; B = 2.6/6.5 = 0.40 — A is higher.
- +1Read the numbers: on IR, Fund A earns more skill per unit of active risk. B's bigger headline alpha (2.6% vs 1.5%) has a p-value of 0.45 — statistically insignificant, so it may be luck.
- +1A's alpha is a stronger signal (p-value 0.10), its fee is nearly half (0.60% vs 1.15%), and its tighter tracking error suits a core sleeve.
- +1Select Fund A — higher information ratio, more reliable alpha, lower fee drag; B's large alpha is unreliable and comes with more than double the active risk and cost.
Key terms
- Active Share
- The fraction of a fund's holdings that differ from its benchmark, Active Share = ½ Σ |w_Fund,i − w_BM,i|. Near 0% for an index fund, toward 100% for a fund sharing no names with its benchmark. It measures how ACTIVE a fund is — not how good; the course stresses the evidence that it predicts outperformance is mixed.
- Information ratio (IR)
- Active return divided by active risk, IR = alpha / tracking error. The single best measure of active skill: it rewards outperformance earned efficiently, without wild deviations from the benchmark.
- Tracking error (TE)
- The standard deviation of the fund's return minus its benchmark's return — a relative (benchmark-dependent) risk measure. Passive funds keep it tiny; a large TE means the manager is running a lot of active risk.
- R²
- The proportion of a fund's return variance explained by its benchmark. High R² means index-like behaviour — a warning sign for an ACTIVE fund, because it can indicate closet indexing.
- Capture ratio
- The fund's return as a percentage of the benchmark's in up markets (up-capture) or down markets (down-capture). A skilled fund wants up-capture above 100 and down-capture below 100.
- Quartile / percentile rank
- A fund's standing within its peer category. Q1 is the top 25%, Q4 the bottom 25%. In Morningstar convention a LOW percentile is good — 1st percentile is the best, 100th the worst.
- Closet indexer
- A fund that charges active fees while delivering near-passive exposure — the tell-tale signature is high R², low tracking error and low Active Share. Unmasking it is a core purpose of fund analysis.
Mutual Fund Analysis (Part 1) FAQ
Is a high Active Share a reliable sign a fund will outperform?
No. The course is explicit that the evidence Active Share PREDICTS outperformance is mixed. It only tells you how different a fund is from its benchmark, not how good it is — a manager can be very active and very wrong. Pair it with bottom-up analysis (holdings, process, alpha reliability) before drawing a conclusion. Treating Active Share as a standalone buy signal loses the discussion mark.
What is the difference between the Sharpe, Treynor and information ratios?
All three are reward-to-risk measures that differ in the denominator. Sharpe divides excess return by TOTAL risk (σ); Treynor divides it by SYSTEMATIC risk (β); the information ratio divides ALPHA by active risk (tracking error). Sharpe and Treynor rank a fund's total performance; the information ratio is the sharpest read on active skill per unit of active risk, which is why selection committees lean on it.
How do I read a percentile or quartile ranking correctly?
Rank a fund inside its own peer category, over several horizons (YTD, 1/3/5/10-year). Q1 is the top quartile and Q4 the bottom. The trap is the percentile scale: in Morningstar convention a LOW number is GOOD — the 1st percentile is the best and the 100th the worst — so a 'high percentile' means poor relative standing. Always confirm the direction of the scale before calling a fund a strong performer.
Why is a big alpha not always a reason to pick a fund?
Because a large headline alpha can be statistically insignificant — a high p-value means it could easily be luck rather than repeatable skill. The exam plants exactly this: a fund with an eye-catching alpha and a weak p-value. Always check the significance of alpha and its net-of-fee size before believing it; a reliable, cheaper, tighter-tracking fund usually wins for a core sleeve.
When is it worth paying for active management instead of an index fund?
Only when a manager shows significant, net-of-fee alpha and a healthy information ratio, with standing that persists across horizons. The course's evidence is sobering: most active funds do not beat a comparable benchmark net of costs, good performance does not persist, and fees compound with certainty while alpha does not. Watch for the closet indexer — high R², low tracking error and active fees — which delivers passive exposure at active prices.
Exam move
Split your Topic 8 prep between calculation and judgement. Drill the ratios until they are automatic — Sharpe = (r̄ − rf)/σ, Treynor = (r̄ − rf)/β, information ratio = alpha/tracking error, and Active Share = ½ Σ |w_Fund − w_BM| — and be able to sort every measure into absolute (Sharpe, SD, VaR, drawdown) versus relative (beta, R², tracking error, information ratio, capture ratios). Then rehearse the judgement move the exam actually rewards: given two funds that tie on the headline ratios, break the tie on the information ratio, the statistical significance of alpha (p-value), the net-of-fee cost, and the fund's role (low tracking error for a core sleeve). Memorise the three traps — Active Share is not a proven predictor, the percentile scale runs backwards (1st = best), and a big insignificant alpha is a decoy — and remember that this chapter is the analytical heart of the group assignment's fund-selection section, so working the ratio-plus-decision example is direct assignment practice. Confirm the exact assessment weightings and any provided-materials policy in your course outline.
