Information Ratio: Meaning, Formula & Example

What Is Information Ratio?

Information Ratio (IR) is a performance measurement metric that evaluates the returns generated by a portfolio compared to its benchmark. It measures the excess return earned over the benchmark in relation to the consistency of those excess returns.

In simple terms, the Information Ratio helps assess whether a portfolio has generated additional returns compared to its benchmark and how consistently those additional returns have been achieved.

A higher Information Ratio indicates that the portfolio has generated higher excess returns relative to the benchmark for the level of active risk taken. However, the ratio should be evaluated along with other performance factors and investment information.

The Information Ratio is commonly used for actively managed portfolios where fund managers make investment decisions to generate returns different from the benchmark.

Uses Of The Information Ratio (Investors & Fund Managers)

The following are some common uses of the Information Ratio:

Comparing Portfolio Performance

The Information Ratio helps compare a portfolio’s performance with its benchmark. It provides insight into how much additional return a portfolio has generated compared to the benchmark.

Evaluating Active Management

Fund managers use this ratio to review the effectiveness of active investment decisions. It helps analyse whether portfolio changes have contributed to returns above the benchmark.

Measuring Consistency Of Returns

The Information Ratio considers the consistency of excess returns rather than looking only at total returns. This helps in understanding how frequently a portfolio has outperformed or underperformed its benchmark.

Analysing Risk-Adjusted Performance

The ratio considers active risk, also known as tracking error, while measuring excess returns. This provides a perspective on returns generated for the additional risk taken against the benchmark.

The Formula For Calculating The Information Ratio

The Information Ratio is calculated by dividing the portfolio’s excess return over the benchmark by the tracking error.

Information Ratio Formula:

Information Ratio = (Portfolio Return − Benchmark Return) ÷ Tracking Error

Where:

• Portfolio Return refers to the return generated by the investment portfolio.
• Benchmark Return refers to the return generated by the market index or benchmark used for comparison.
• Tracking Error refers to the difference between portfolio returns and benchmark returns.

A higher tracking error indicates greater variation between portfolio performance and benchmark performance. A lower tracking error indicates that portfolio returns are closer to benchmark returns.
 

Steps To Calculate Information Ratio

The following steps explain how the Information Ratio is calculated:

Step 1: Calculate Excess Return

First, calculate the difference between the portfolio return and benchmark return.

Excess Return = Portfolio Return − Benchmark Return

Step 2: Calculate Tracking Error

Tracking error measures the variation between portfolio returns and benchmark returns over a period.

Step 3: Apply The Formula

Divide the excess return by the tracking error.

Information Ratio = Excess Return ÷ Tracking Error

Example Of Information Ratio

The following example explains the calculation of the Information Ratio.

Assume a mutual fund portfolio generates a return of 14% in one year. The benchmark return during the same period is 10%.

The difference between the portfolio return and benchmark return is:

Excess Return = 14% − 10% = 4%

Now assume the tracking error of the portfolio is 5%.

Using the Information Ratio formula:

Information Ratio = 4% ÷ 5%

Information Ratio = 0.8

In this example, the Information Ratio is 0.8. This indicates that the portfolio generated excess returns compared to the benchmark in relation to the tracking error during the period considered.

How Is Information Ratio Useful? (For Investors Vs. Fund Managers)

The Information Ratio may be used differently by investors and fund managers while analysing investment performance.

For Investors

Investors may use the Information Ratio as one of the metrics to understand how a fund has performed compared to its benchmark. It provides information about the relationship between excess returns and active risk.

The ratio may help investors compare funds that follow active management strategies. However, investors may also consider other factors such as investment objectives, risk factors, and portfolio details while reviewing a fund.

For Fund Managers

Fund managers use the Information Ratio to evaluate portfolio management decisions. It helps analyse whether active investment choices have generated returns above the benchmark while considering the level of deviation from the benchmark.

The metric can also support portfolio review by identifying areas where investment strategies may require further analysis.

Information Ratio Vs. Sharpe Ratio

Information Ratio and Sharpe Ratio are both performance measurement tools used to evaluate investment returns in relation to risk. However, they measure different aspects of portfolio performance.

The Information Ratio compares a portfolio’s excess return against its benchmark while considering tracking error. It focuses on the additional returns generated through active management decisions.

The Sharpe Ratio measures returns earned over the risk-free rate in relation to the total risk taken by the investment. It considers overall volatility instead of only the difference between portfolio and benchmark returns.

The choice between these ratios depends on the purpose of analysis. The Information Ratio is generally used for comparing actively managed portfolios with their benchmarks, while the Sharpe Ratio provides information about returns relative to overall risk.

Limitations of the Information Ratio

The following are some limitations of the Information Ratio:

• The Information Ratio depends on the selection of the benchmark. A benchmark that does not closely represent the portfolio may affect the relevance of the comparison.
• The ratio mainly focuses on historical performance and may not represent future portfolio performance.
• The calculation may vary depending on the time period considered and the method used for measuring tracking error.
• The Information Ratio does not provide details about factors such as investment strategy, portfolio composition, or market conditions.
• A single ratio may not provide a complete view of investment performance and may need to be reviewed with other performance measures.

Information Ratio Vs. Sharpe Ratio: Comparison Table

The following table highlights the key differences between Information Ratio and Sharpe Ratio:

Information Ratio Vs. Alpha And Beta

Information Ratio, Alpha, and Beta are different measures used to analyse various aspects of investment performance.

Alpha measures the excess return generated by a portfolio compared to its expected return based on market conditions. It indicates whether a portfolio has performed above or below its expected level.

Beta measures the sensitivity of a portfolio’s returns compared to market movements. A beta value indicates how much a portfolio may move in relation to changes in the benchmark.

The Information Ratio focuses on excess returns compared to a benchmark while considering tracking error. Unlike Alpha and Beta, it evaluates the consistency of active returns rather than only market-related performance.

These metrics provide different information and may be considered based on the purpose of investment analysis.

What Is A Good Information Ratio?

The Information Ratio does not have a fixed value that applies to all investments. The interpretation may depend on factors such as the investment strategy, asset class, benchmark, and time period considered.

Generally, the following scale is used as a reference:

• Below 0: Indicates that the portfolio has generated lower returns compared to the benchmark after considering tracking error.
• Around 0: Indicates that the portfolio performance is close to the benchmark after considering active risk.
• Above 0: Indicates that the portfolio has generated excess returns compared to the benchmark.
• Higher values: May indicate stronger excess returns relative to tracking error.

Investors and fund managers may review the Information Ratio along with other performance indicators and relevant portfolio details to understand investment performance.

Conclusion

The Information Ratio is a metric used to evaluate portfolio performance by comparing excess returns against a benchmark while considering tracking error. It helps understand the relationship between additional returns and active risk taken by a portfolio. However, the ratio has certain limitations and should not be viewed in isolation. Reviewing other performance measures, portfolio details, and investment-related information can provide a broader understanding of portfolio performance.