Understanding Information Ratio

This comprehensive guide demystifies the intricacies of Information Ratio in mutual funds.
Understanding Information Ratio
3 mins read
19 Mar 2024

Ratio analysis is crucial in financial markets. It plays a big role in decision-making across all aspects of investing. Although mutual funds investing is said to be pretty easy because the fund managers and asset management companies handle everything. It is crucial to keep tabs on your investments regularly. While using the benchmark index is a basic way to check how well your fund is doing, it should not be the only thing serious investors rely on.

There are many metrics available to calculate the performance of your investment. Each ratio shows different aspects of market dynamics. One of these metrics is the information ratio or IR, which is valuable for both investors and professionals in the market.

What is information ratio (IR)?

The information ratio (IR) quantifies the performance of an investment portfolio or asset concerning a benchmark index, integrating volatility of returns into its assessment. Essentially, it gauges the excess returns generated by a portfolio relative to a benchmark while considering the consistency of outperformance, termed as tracking error.

Analysing mutual funds using the information ratio

There are two main approaches to managing mutual fund investments: active management and passive management. Active management involves manual strategising of fund allocation and timing of transactions, while passive management mirrors the market by investing in an index. Active management increases your expense ratio (fees), so it is crucial to ensure that the fund manager's approach positively contributes to fund performance.

The information ratio (IR) assesses the reliability and expertise of an asset manager in minimising risks and outperforming the benchmark. It determines whether the manager consistently surpasses the benchmark by a significant margin on a quarterly or monthly basis. The IR evaluates how successful the fund's strategy is in its investments and allocations. By using the IR, you can compare the additional returns generated by the mutual fund against market fluctuations. In essence, a mutual fund investment entails more than just its returns.

Uses of the information ratio

The information ratio (IR) holds significant value for both investors and fund managers alike.

  • Investors frequently rely on the IR when evaluating mutual funds or ETFs, using it as a yardstick to assess a fund manager's competence and to compare managers employing similar investment strategies.
  • Fund managers utilise the IR to evaluate their performance and establish their service charges; a higher IR for a portfolio manager often translates to higher service fees.

Ultimately, the information ratio empowers investors and fund managers to make informed decisions by offering insights into a portfolio's performance relative to a benchmark, taking into account consistency and risk-adjusted returns.

Did you know? You can also get an estimate of the future value of your mutual funds investments by using the Bajaj Finserv SIP Calculator, eventually helping you to make informed decisions.

How to calculate the information ratio?

The information ratio (IR) is calculated using a simple formula:

IR = (Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking Error


The tracking error represents the standard deviation of the investment portfolio's excess returns compared to the benchmark.

To annualise the information ratio, multiply IR by the square root of 252, which represents the number of trading days in a year.

The formula for annualised IR is:

[(Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking error] x √252


Here's a step-by-step guide to calculating the information ratio with basic data:

  • Step 1: Record the daily returns of a portfolio over a specific period, such as a month, quarter, or year.
  • Step 2: Calculate the average of these returns to determine the portfolio's rate of return.
  • Step 3: Calculate the benchmark's rate of return using the same method.
  • Step 4: Subtract the benchmark returns (Step 3) from the portfolio returns (Step 2) to find the difference.
  • Step 5: Calculate the standard deviation of the portfolio's excess returns.
  • Step 6: Divide the difference in returns (Step 4) by the tracking error (Step 5) to obtain the Information Ratio.

For example, let's consider a portfolio with a 11% rate of return, while the benchmark shows an 7% rate of return, with a tracking error of 5%.

Therefore, IR = (11% – 7%) / 5%

So, IR = 0.8

What’s the difference between the information and Sharpe ratio?

Criteria

Information ratio

Sharpe ratio

Definition

Quantifies the risk-adjusted surplus returns concerning a benchmark index.
Evaluates the risk-adjusted surplus returns compared to a risk-free rate like treasury securities.

Objective

Assesses a portfolio manager's capability to consistently produce surplus returns relative to a benchmark.
Measures the overall risk-adjusted performance of a portfolio in comparison to a risk-free investment.

Calculation

(Portfolio Return - Benchmark Return) / Tracking Error

(Portfolio Return - Risk-Free Rate) / Standard Deviation of Portfolio Returns

Risk measurement

Tracking Error (standard deviation of excess returns)

Standard Deviation of Portfolio Returns

Benchmark/ Index

Benchmark index like Nifty 50, BSE Sensex, etc

Risk-free rate, like Indian Government Bond yields, etc

Use in Indian market

Evaluating actively managed mutual funds or portfolios against Indian market indices. Assessing the risk-adjusted performance of portfolios concerning Indian risk-free assets.

 

Conclusion

The information ratio, along with other metrics, holds significant importance in financial markets. It helps compare the performance of actively managed funds against specific market indices, while the Sharpe ratio evaluates the risk-adjusted performance of portfolios with respect to risk-free assets, such as Indian Government Bonds. When applied correctly, these metrics enable investors to make more informed investment decisions.

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