What is “Information Ratio?”
The Information ratio measures the excess return of a portfolio over a benchmark, which is a predetermined one, but also looks at the variability of that excess return. The excess returns generated by the investment portfolio is compared to the volatility of those returns through the information ratio, which in turn reflects an active fund manager’s success vis-à-vis investment strategies.
This ratio helps investors answer two very important questions about an active investment manager’s performance. Did the manager outperform the benchmark and were they able to outperform the benchmark consistently? If the answer to either of these questions is yes (no), it would result in a higher (lower) Information Ratio. A higher information ratio is indicative of better risk-adjusted performance of the investment portfolio.
Key Learning Points
- A higher information ratio is preferred, as it indicates better risk-adjusted performance of a portfolio.
- The Information ratio is used by investors to make investment decisions pertaining to investing in mutual funds or exchange-traded funds.
- A fund that has a higher Information ratio, compared to another fund, indicates that the former can generate excess returns more consistently than the latter.
Information Ratio – Importance, Formula and Disadvantages
The information ratio helps in evaluating an active investment manager’s ability to generate excess returns sustainably, or generate abnormally high returns over a period of time. This ratio is used by investors to make investment decisions vis-à-vis investments in mutual funds or exchange-traded funds (ETFs), predicated on their respective risk taking capacity or appetite.
The Information ratio is computed by dividing the excess rate of return of the investment portfolio minus the benchmark rate of return by the standard deviation of the excess return vis-à-vis the benchmark rate of return.
Information Ratio formula:
Information ratio = (Rp – RB)/ σ (p-B)
Rp = Investment portfolio’s rate of return
RB = Benchmark rate of return
(Rp – RB) = Excess returns over benchmark i.e. return on a portfolio – return on a benchmark (also called as active return)
σ (p-B) = Standard deviation of these excess returns (this is also known as active risk or tracking error).
The tracking error, basically, reflects how the performance of the investment portfolio deviates from its benchmark’s performance. Higher (lower) the difference between the returns on the portfolio and benchmark returns, the larger (smaller) is the tracking error. For an active investment manager, the tracking error tends to be higher, whereas, in the case of a passive fund manager, the tracking error is expected to be very low, given that such a manager seeks to mirror or replicate the predetermined benchmark.
The higher this ratio, the better it is. If the information ratio is less than zero, it means that the active manager failed on the first objective of outperforming the benchmark.
Many see this ratio as a Sharpe ratio in a different form. But in the end, it is tracking the reward earned by a portfolio manager per incremental unit of risk taken on by him or her. Here, the incremental unit of risk is created by how much the portfolio manager chooses to deviate from the benchmark.
Information Ratio, Example
Given below is an example of two hedge funds – Fund A and Fund B. An investor wants to investment in either of them, for which he or she wants to compare the information ratio of both hedge funds.
The chosen benchmark for the calculation of the Information ratio of both the hedge funds is the US stock market benchmark – the S&P 500. Given below is the information on both these funds i.e. Fund A and Fund B returns, and standard deviation of portfolio returns of both these hedge funds from the return of the S&P 500 are given.
Based on the information given below, the Information ratio of Fund A (42.86%) has been calculated, using the formula stated above.#
Likewise, the information ratio of Fund B (36.6%) is calculated. Based on the Information ratio, the investor may want to invest in Fund A, rather than Fund B, as the former has a higher ratio than the latter. This indicates that Fund A can generate excess returns more consistently, relative to Fund B.