Modified IR As a Predictor of Fund Performance

Abstract

One of the most crucial decisions for investors and plan sponsors is the selection of funds among the thousands of available alternatives. We stress that an investor first needs to specify a target alpha, i.e., the expected fund return in excess of a benchmark, and that the target alpha determines the types of funds that are most likely to fulfill that objective. We propose a modified Information Ratio (IR), i.e., the average past alpha above both the benchmark and the target alpha, scaled by tracking error, as a screening tool for future fund performance. We find that the Modified IR is a better predictor of future fund performance than many of the other predictors in the literature, including past performance (alpha) of the fund, the fund's past tracking error, active share, the fund's intercept in regressing its return on the Fama-French factors, and that regression's R2. Consistent with intuition, we find that as the target alpha increases, "winner" funds, i.e., those in the top quintile during the past 36 months according to the Modified IR and which were also able to achieve the target alpha, have higher tracking error, fewer stock holdings on average, higher expense ratio, higher active share, higher turnover ratio, and are smaller in terms of Total Net Assets (TNA). However, we also find that the actual average annual return on "winner" funds in the year after fund selection does not increase with target alpha, and that the higher the target alpha selected by the investor the lower the likelihood of actually attaining it. Finally, for any given target alpha, past "winner" funds that were able to achieve the target alpha in the prior 36 months vary considerably in the number of positions that they have in their portfolio. However, we find that past "winner" funds with a larger number of holdings are more likely to have better future performance than those that are more concentrated and have higher active share. These results point to the advantages of performance consistency that is more likely to be achieved through diversified portfolios.