Understanding the Information Ratio (IR)
The Information Ratio (IR) is a powerful metric that quantifies portfolio returns exceeding those of a selected benchmark, often an index, taking into account the volatility of those returns. By comparing a portfolio’s performance to a benchmark, the IR serves as a vital tool in evaluating a portfolio manager’s skill and consistency in generating excess returns while managing risk.
Investors and finance professionals employ the IR to gauge not just outperformance, but the regularity of that outperformance, using tracking error—a measure of return volatility relative to the benchmark—as a key component in the calculation.
Key Insights
- The Information Ratio (IR) evaluates portfolio returns above a benchmark’s returns, considering the associated return volatility.
- A higher IR indicates a more adept portfolio manager, able to achieve better returns relative to a benchmark, given the risk taken.
Formula for Calculating the Information Ratio (IR)
The formula standardizes returns by dividing the difference between portfolio performance and benchmark performance by the tracking error:
IR = (Portfolio Return − Benchmark Return) / Tracking Error
Where:
- Portfolio Return = Portfolio’s return for the period
- Benchmark Return = Return from the benchmark fund for the period
- Tracking Error = Standard deviation of the difference between portfolio and benchmark returns
Calculation involves subtracting the benchmark return from the portfolio return and then dividing the result by the tracking error, which can be determined using the standard deviation of the return differences.
Interpreting the Information Ratio (IR)
Consistency is Key
Higher IR values reflect consistent outperformance relative to a benchmark, an sought trait by investors seeking reliable returns. Conversely, low IR values signal less dependable performance. Investors commonly factor the IR when selecting ETFs and mutual funds matching their risk tolerance and investment objectives.
Comparing with the Sharpe Ratio
While both IR and the Sharpe Ratio assess risk-adjusted returns, their applications differ. The Sharpe Ratio measures returns over the risk-free rate, whereas the IR compares returns to a market benchmark, making it more practical for index-based performance evaluations.
Example of Utilizing the IR
To practically understand the IR, consider Fund Manager A and Fund Manager B:
- Fund Manager A: Annualized return = 13%, Tracking error = 8%
- Fund Manager B: Annualized return = 8%, Tracking error = 4.5%
- Benchmark Index: Annualized return = -1.5%
Calculating IR:
- A’s IR = (13 - (-1.5)) / 8 = 1.81
- B’s IR = (8 - (-1.5)) / 4.5 = 2.11
Despite lower returns, Fund Manager B demonstrates a better IR due to lower tracking error, indicating more consistent performance with less risk.
Optimal Information Ratio Ranges
A good IR starts at 0.5, with values above this threshold indicating progressively better results. IR values of 1 and above are considered excellent indicators of a portfolio manager’s effectiveness.
Limitations of the Information Ratio
Interpreting the IR varies by investor, shaped by individual risk tolerance, financial situations, and investment goals. Moreover, comparing multiple funds’ IRs can be complex owing to differing securities, allocations, and investment timing. Complementing the IR with additional financial metrics is advisable for comprehensive investment evaluations.
Bottom Line
The Information Ratio is crucial for assessing ongoing portfolio outperformance against a benchmark, aiding in decisions whether to choose actively managed funds or opt for passively managed funds with typically lower costs and comparable, if not better, performance against market benchmarks.
Related Terms: Sharpe Ratio, Risk-Adjusted Returns, Standard Deviation, Active Return, Tracking Error
