Information Ratio (Investments) - Explained
What is an Information Ratio?
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Table of ContentsWhat is an Information Ratio?How is the Information Ratio Used? How to Calculate the Information RatioWhat Does the Information Ratio Tell You?The Difference Between IR and the Sharpe RatioLimitations of Using IR
What is an Information Ratio?
The Information Ratio (IR) is a ratio that measures the performance of an investment, fund or portfolio by comparing the returns generated with the returns of a benchmark, usually a market index. IR measures the excess returns of a portfolio compared to the returns of a benchmark. This ratio is also used in evaluating the level of skill of a portfolio manager, by checking how much returns the portfolio of investment being managed generated. The information ratio draws this comparison after adjusting the returns for its additional risk or account for the volatility of the returns. IR is otherwise called the appraisal ratio.
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How is the Information Ratio Used?
The information ratio seeks to evaluate the performance of an investment by comparing its excess returns with the returns of the benchmark, giving consideration to the volatility of the returns. The formula for calculating IR contains a standard deviation component which is also a tracking error. IR is calculated as the active return divided by the tracking error. The formula for calculating IR is: IR= PortfolioReturnBenchmarkReturn/TrackingError. In the above formula, the tracking error measures how consistent a portfolio is in outperforming or beating the returns of the benchmark. If the tracking error is low, it indicates that the portfolio consistently outperforms the benchmark over a period of time and when it is high, it means the portfolio was unable to consistently exceed the benchmark due to volatility and other factors.
How to Calculate the Information Ratio
The Information Ratio is the measure of portfolio or investment returns above the returns of a benchmark. The benchmark as used in every market is a representation of the market, its returns, and volatility. The following are the necessary steps when calculating the IR;
- Calculate the total return of a portfolio for a particular period.
- Subtract the given value from the total return of the market index or benchmark.
- Divide the difference by the tracking error or standard deviation component.
What Does the Information Ratio Tell You?
First, the information ratio tells how much a portfolio's return exceeds the return of the benchmark and at what level of consistency. Secondly, IR tells us the level of skill of a portfolio manager and how successful is the strategy deployed in an investment. Investors, market analysts, and traders pay attention to the information ratio when selecting investment instruments that will give them the highest level of return for their underlying risk Usually, high information ratios show that the return of a portfolio exceeds the return of a benchmark at a desirable level of consistency. It also shows how much return portfolio gives compared to volatility. When calculating an information ratio, a tracking error is including using the standard deviation of the difference in returns of a portfolio and the benchmark. When there is high volatility, and less consistency, a high tracking record or standard deviation will be recorded while a low tracking record shows less volatility and higher consistency. The most important points to know about the information ratio are;
- The Information Ratio is the measure of the total returns of a portfolio above the total returns of a benchmark compared to the volatility of the returns.
- A benchmark refers to an index that represents a market, industry or sector such as the S&P 500.
- IR also tells us the level of skill of a portfolio manager through the success of the strategies deployed in managing a portfolio.
- When calculating the IR, a tracking error is included using the standard deviation of the difference between the portfolio and the benchmark.
- A higher information ratio indicates that a portfolio generates excess returns with a good level of consistency over the benchmark.
The Difference Between IR and the Sharpe Ratio
The Sharpe ratio has similar functions as the information ratio because it helps investors understand the level of return of an investment compared to its risk. While the information ratio measures the excess returns of a portfolio above the total returns of a benchmark compared to the volatility of the returns, the Sharpe ratio measures the performance (return) of an investment compared to the risk-free rate of return, after adjusting for risk. Both the information ratio and the Sharpe ratio are vital to investors and market analysts as it helps them make informed decisions. However, investors often use the IR since it compares the returns of an investment to the returns of a benchmark, considering the volatility of the returns.
Limitations of Using IR
The fact that the information ratio measures the risk-adjustment returns of an investment which exposes it to diverse interpretations is a major drawback of the ratio. Given that IR can be interpreted differently by many investors due to the influence of preference, investment goals, and risk tolerance levels, it might not be an accurate ratio when making investment decisions. Another argument against the information ratio is that it is better used for simple investment portfolios and not multiple funds, given that comparing multiple funds to a benchmark can give rise to complications in the ratio.