Evaluating absolute return managers

One traditional measure of investment performance, the information ratio (IR), is defined as the active return (alpha) divided by the tracking error (the standard deviation of the active return). Calculating an IR is straightforward when the benchmark for performance is a buy-and-hold standard like the S&P 500. For absolute return managers, however, the typical benchmark is zero, meaning that any excess return is classified as alpha and deemed to represent the return from active management or skill. In this paper, we argue that this standard approach confuses beta returns and alpha returns. The former can be earned by following generic strategies that are easily implemented and often replicated by ETFs, while the later are associated with more original or complex strategies that more genuinely reflect unique skills or expertise. We propose a new performance metric that strips out beta returns associated with investment-style factors. This approach leads to a new statistic, the alpha ratio, which can dramatically impact the relative performance rankings of managers and provide a clearer signal of manager skill. Copyright Swiss Society for Financial Market Research 2014