Case 063Products and fund selectionCore

Choose a core large-cap fund from three schemes, given their 5-year returns, expense ratios, tracking error against the benchmark and information ratios.

The situation

A client's portfolio needs one core large-cap fund, the holding meant to track the broad market with a modest edge and sit untouched for a decade. Over five years the large-cap benchmark returned 12.0% a year. The three shortlisted schemes, returns shown after their expenses:

Maitri Large Cap Fund: 13.1% a year, expense ratio 1.00%, tracking error 3.0%. Sthira Bluechip Fund: 12.6%, expense ratio 0.60%, tracking error 1.2%. Varuni Focused Fund: 14.4%, expense ratio 1.40%, tracking error 7.5%, holding about 25 stocks across market sizes.

Your task

Which fund would you pick for the core slot, and what numbers decide it?

Quick check

Which fund has the best information ratio?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Sthira Bluechip for the core slot. It has the highest information ratio, 0.50, earning 0.6 points over the benchmark with only 1.2 points of tracking error and the lowest expense ratio. Varuni's 14.4% headline comes with 7.5 points of tracking error, an information ratio of 0.32, and a focused, multi-cap portfolio that does not belong in a large-cap core. Five years is short, so treat the ranking as a lean, not a proof.

Step 1Why is the highest return not the answer?

Two drivers reach the same town; one took the highway and one cut across fields and rivers. Arriving five minutes earlier does not make the second the better driver for the school run. A core fund's job is to beat its benchmark reliably, so what matters is how much excess return it earned for each unit of distance it strayed from the benchmark. That distance is tracking errorThe standard deviation of the difference between a fund's return and its benchmark's, a measure of how far it strays.; excess return divided by it is the information ratio.

The relationship

\text{IR} = \frac{R_{fund} - R_{bench}}{\text{TE}} \qquad \text{Sthira: } \frac{12.6 - 12.0}{1.2} = 0.50 \qquad \text{Varuni: } \frac{14.4 - 12.0}{7.5} = 0.32

R	five-year annual return after expenses
TE	tracking error, in percentage points a year
IR	information ratio, excess return per point of tracking error

What it says in wordsThe information ratio is how much a fund beat its benchmark for each point it wandered away from it.

Varuni Focused has the highest five-year return at 14.4% but the lowest information ratio, 0.32, because it strayed 7.5 points from the benchmark; Sthira Bluechip earns 0.50 with 1.2 points of tracking error and the lowest expense ratio.

Step 2What else separates the three?

Cost and style. Sthira's 0.60% expense ratio is the lowest, and cost is the one number that reliably carries forward: a fund must beat its benchmark by at least its fee just to break even against a cheap index fund. Maitri charges 1.00% for an information ratio of 0.37. Varuni is a focused fund holding about 25 stocks across market sizes; whatever its skill, it is not a large-cap core holding, and putting it there means the client's core behaves like a concentrated bet.

Fund	Return	Expense	Excess	TE	IR	IR x root 5
Maitri Large Cap	13.1%	1.00%	+1.1	3.0	0.37	0.82
Sthira Bluechip	12.6%	0.60%	+0.6	1.2	0.50	1.12
Varuni Focused	14.4%	1.40%	+2.4	7.5	0.32	0.72

Sthira has the highest information ratio at 0.50, but multiplied by the square root of five years it gives only 1.12, below the rough 2.0 needed before an edge can be told apart from luck.

Step 3How confident can you be on five years of data?

Not very, and saying so is part of a good answer. A rough test of whether an edge is real is the information ratio times the square root of the years measured; Sthira scores 1.12 and Varuni 0.72, both well below the 2.0 that would suggest skill rather than luck. So the pick rests on three things together: the best risk-adjusted record, the lowest cost and the right style. The limit worth naming is the one a client should hear: a low-cost index fund is the fair comparison for any core slot, and none of the three has yet proved it beats one.

Where candidates lose it

The common error is picking Varuni for its 14.4% and stopping there. The interviewer gave you tracking error so you would see that its excess return came with the most wandering, and gave you its style so you would see it does not fit a large-cap core.

The second miss is treating 0.50 against 0.32 as proof. Five years cannot separate skill from luck at these levels; say that, and lean on cost and fit as well.

What the interviewer asks next

How would you compare Sthira with a large-cap index fund charging 0.20%?
Where in the client's portfolio, if anywhere, could Varuni belong?
What would make you replace Sthira in two years' time?

Company names and figures are illustrative.