Information Coefficient (IC)
The information coefficient (IC) is a statistical measure of the merit of a predicted value as well as an evaluation of the proficiency or expertise of an investment analyst. Basically, the information coefficient measures the relationship (correlation) between the predicted value and the actual outcome of an event. It also shows how skillful a portfolio manager or investment analyst is.
Depending on the outcome of the analysis, the information coefficient ranges from +1.0 to -1.0. -1 means the analyst’s forecast has no correlation with the actual results. 1 means there is a perfect match between the forecasted values and the actual results.
The formula below is used for the calculation of Information Coefficient;
IC = (2 × Proportion Correct) −1
Proportion Correct=Proportion of predictions made correctly by the analyst
Explaining the Information Coefficient
Essentially, the information coefficient explains the correlation between a predicted value and actual results or actual stock returns. A match or correlation between these two values is a reflection of the skill of a portfolio manager or investment analyst. While an IC of +1.0 shows a perfect match between the predicted value and the actual returns, an IC of 0.0 shows that there is no correlation whatsoever between the two values. However, an IC of -1.0 indicates that an analyst does not make a correct prediction.
Information Coefficient is a core component of the Fundamental Law of Active Management. In the information coefficient, the skills of an analyst are matched with his ability to give correct predictions about a stock return.
- The information coefficient shows to what extent the forecasts of an investment analyst or portfolio manager matches the actual results.
- It measures the merit of predicted value and the skill of the investment or financial analyst.
- The information coefficient (IC) is not the same as the Information Ratio (IR), the latter us a measure of an analyst’s or manager’s skill by evaluating the excess returns of an investment to the level of risk taken.
- The Information Coefficient ranges from +1.0 to -1.0. while an IC of +1.0 shows a perfect match between the prediction and actual returns, an IC of 0.0 indicates zero matches and an IC of -1.0 shows that the analysts make incorrect predictions.,