Evaluating Fund Managers and Active vs. Passive

Evaluating active fund managers requires decomposing their returns into beta (market exposure return) and alpha (excess return above what market exposure alone would explain). Any manager holding stocks will have market exposure — they deserve no credit for gaining in a bull market. Alpha is the return attributable to skill, security selection, or strategy — the return earned after accounting for market exposure. Jensen's alpha: α = R_fund − [R_f + β(R_market − R_f)], where R_f = risk-free rate, β = fund's market beta. Positive alpha = manager earned more than their level of market exposure would predict. Importantly, alpha must be risk-adjusted: a manager who earns 2% alpha by taking on hidden tail risks (leveraged bets, illiquid holdings) has not demonstrated genuine skill. The Sharpe ratio = (R_portfolio − R_f) / σ_portfolio measures risk-adjusted return per unit of total risk. The Information Ratio (IR) = α / tracking error (TE) measures the consistency of alpha generation. Tracking error is the standard deviation of the difference between the fund's returns and the benchmark's returns. A high IR (> 0.5 is considered good) indicates consistent alpha generation relative to benchmark deviation taken. The IR is the most important single metric for evaluating an active manager because it captures both the magnitude and consistency of skill.