Information Ratio

The information ratio (IR) assesses a portfolio manager's ability to outperform a benchmark, often the S&P 500, relative to the volatility of returns. It gauges skill in generating excess returns.
Information Ratio
3 mins read
13-June-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.

The information ratio is a metric used to assess how well a portfolio manager outperforms a chosen benchmark after accounting for the risk involved. It essentially measures the "bang for the buck" of excess returns generated by the manager. A higher IR indicates the manager's ability to consistently deliver returns that exceed the benchmark, while also managing risk.

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.

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Formula of information ratio

Here is the formula for calculating information ratio:

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

 

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.

Information ratio calculation example

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

IR: (11% – 7%) / 5%

So, IR = 0.8

How is the information ratio useful?

For investors seeking mutual funds or ETFs, IR becomes a key metric. While past performance isn't a crystal ball for the future, IR provides valuable insights into a fund manager's skills. Investors can compare funds with similar investment styles using IR to identify managers who consistently deliver excess returns relative to the risk taken (measured by tracking error).

  • Understanding IR with an example: Imagine two funds, A and B, with annual returns of 14% and 10% respectively. Fund manager A's portfolio exhibited more volatility (tracking error of 9%), while B's was more stable (tracking error of 4%). The benchmark index returned 4% annually.
  • Calculating the IR:
    • Fund A: IR = (14% - 4%) / 9% = 1.11
    • Fund B: IR = (10% - 4%) / 4% = 1.5

Despite A's higher returns, a lower IR indicates less consistency in exceeding the benchmark compared to B. This might lead investors to favour B based on their more consistent performance.

  • Fund managers and service charges: The information ratio also serves as a benchmark for fund managers themselves. A higher IR often translates to a higher service charge, as it reflects the manager's ability to outperform the market while managing risk.
  • The takeaway: By analysing the information ratio, both investors and fund managers gain valuable insights. Investors can use it to select funds with strong risk-adjusted performance, while fund managers can leverage it to demonstrate their expertise and potentially command higher fees.

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

Listed below are the key differences between information ratio and Sharp 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.

What are the limitations of IR?

Here are some limitations of IR: 

  • Risk-adjusted measure: Similar to the Sharpe Ratio, the Information Ratio (IR) assesses a portfolio's returns relative to a benchmark, but with a focus on risk.
  • Interpretation varies: Unlike simpler metrics, IR's meaning can differ depending on the investor. Factors like risk tolerance, investment goals, age, and income can influence how someone views on IR value.
  • Portfolio specificity: IR is specific to each portfolio. Two portfolios with different asset allocations, securities, and entry points won't be directly comparable based solely on IR.
  • Complementary metric: For a more comprehensive picture, use IR alongside other metrics to assess portfolio performance.

Key Takeaways

  • Ratio analysis is crucial in financial markets, aiding decision-making in investing. While mutual fund investing seems straightforward, regular monitoring is essential.
  • IR assesses how effectively a portfolio manager outperforms a chosen benchmark while considering risk. A higher IR indicates consistent outperformance while managing risk.
  • IR helps evaluate mutual fund performance, crucial for both active and passive management approaches. It assesses a manager's ability to consistently surpass benchmarks, offering insights beyond mere returns.
  • IR serves investors and fund managers alike. Investors use it to evaluate fund managers' competence and compare similar strategies, while fund managers use it to assess their performance and set service charges.
  • The formula for IR involves subtracting benchmark returns from portfolio returns and dividing by tracking error. Investors can use it to identify managers delivering excess returns relative to risk.
  • IR focuses on benchmark index surplus returns while considering risk, whereas Sharpe Ratio evaluates risk-adjusted performance compared to a risk-free rate. Understanding their differences aids in portfolio analysis.

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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Frequently asked questions

What is the information ratio?

The information ratio (IR) measures a portfolio's risk-adjusted performance compared to a benchmark. It considers both excess return (beating the benchmark) and the volatility of those returns.

What is the Information ratio Formula?

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

Here Tracking Error is standard deviation of the excess return.

What is the difference between information ratio and Treynor ratio?

Both measure risk-adjusted performance, but IR uses tracking error (overall volatility) while the Treynor Ratio uses the volatility of only the unexpected return (unexpected market movements).

What is the ideal information ratio?

The ideal information ratio varies depending on individual investment objectives and risk preferences. Generally, a higher information ratio indicates better performance relative to risk. Investors should consider factors like their risk tolerance, investment goals, and the specific market conditions when determining the ideal information ratio for their portfolio.

What is the difference between information ratio and Sortino ratio?

Unlike the information ratio, which assesses overall risk-adjusted performance relative to a benchmark, the Sortino ratio focuses solely on downside risk. Specifically, it evaluates the volatility of negative returns. While the information ratio provides a comprehensive view of risk-adjusted returns, the Sortino ratio offers insights into the portfolio's ability to manage downside risk effectively.

Why is the information ratio negative?

A negative IR indicates the portfolio underperformed the benchmark after considering risk. It could be due to high volatility or simply not beating the benchmark return.

Why is information ratio not necessarily better than Sharpe ratio?

Both are valuable metrics, but IR focuses on how consistently a portfolio beats the benchmark, while Sharpe ratio focuses on overall risk-adjusted return. Choose the metric most relevant to your analysis.

What is a good information ratio for a mutual fund?

A good information ratio for a mutual fund typically falls above 0.5, although this can vary based on factors such as the fund's investment strategy and prevailing market conditions. Investors should aim for an information ratio that reflects consistent outperformance relative to the benchmark while managing risk effectively, ensuring the fund meets their investment objectives.

Is an information ratio of 2 good?

Yes, an information ratio of 2 is generally considered very good. It suggests that the portfolio manager consistently generates twice the excess returns compared to the benchmark relative to the risk taken. A higher information ratio indicates stronger performance relative to risk, making it an attractive metric for investors seeking funds with robust risk-adjusted returns.

Should information ratio be high or low?

Ideally, the information ratio should be high, as it indicates the portfolio manager's ability to consistently outperform the benchmark while effectively managing risk. A higher information ratio signifies stronger risk-adjusted performance, making it a desirable metric for investors evaluating fund managers and selecting investments aligned with their objectives.

What does an information ratio of 0.5 mean?

An information ratio of 0.5 means that for every unit of tracking error, the portfolio manager generates 0.5 units of excess returns compared to the benchmark. While not exceptionally high, a ratio of 0.5 indicates moderate performance relative to risk. Investors may consider this ratio alongside other factors when evaluating the attractiveness of a mutual fund or portfolio.

What is the information ratio strategy?

The information ratio strategy involves utilising the information ratio to evaluate and compare the performance of investment portfolios relative to their benchmarks. By analysing this metric, investors and fund managers can assess the effectiveness of portfolio management strategies in generating excess returns while managing risk. The information ratio strategy aids in decision-making and helps optimise portfolio performance.

What are the benefits of information ratio?

The information ratio offers several benefits for investors and fund managers. It provides valuable insights into a portfolio's risk-adjusted performance relative to a benchmark, aiding investors in evaluating fund managers and selecting investments aligned with their objectives. Additionally, fund managers can leverage the information ratio to demonstrate their expertise and potentially command higher fees based on their performance relative to benchmarks.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.