Information Ratio: Definition, Calculator, Formula and Pros & Cons
The information ratio is a key metric for assessing investment performance against a benchmark. It tells investors how much excess return is achieved per unit of risk. It’s one of many performance metrics in trading and investing.
The relevant question for investors is: Is my portfolio manager doing a good job? Are my trading strategies effective? The information Ratio is one such measure. In this article, you learn how to calculate the information ratio, interpret its values, and use it to scrutinize your investment strategies.
Key Takeaways
- The Information Ratio (IR) is a performance metric that assesses a portfolio’s risk-adjusted returns compared to its benchmark. A higher IR indicates superior risk-adjusted performance.
- A good Information Ratio (IR) typically ranges from 0.4 to 1 or above, with higher values representing better investment manager skill in generating consistent excess returns relative to taken risk and the benchmark index.
- The Information Ratio (IR) focuses on relative returns, not absolute, and is calculated by dividing the excess portfolio return over the benchmark by the tracking error, which measures the consistency of the excess return’s volatility.
Introduction to Information Ratio (IR)
The Information Ratio (IR) measures an investment portfolio’s performance against a benchmark, considering the volatility associated with those returns. It reflects the added value that a portfolio manager brings to an investment strategy and is commonly used by investors, traders, and managers to determine the effectiveness of their strategies.
When assessing risk-adjusted performance, an elevated Information Ratio indicates that the investment portfolio has generated excess returns in proportion to its assumed risk level. Consequently, IR becomes vital when determining if the costs tied with actively managed funds—such as mutual funds or exchange-traded funds (ETFs)—are warranted based on their actual performance outcomes.
What is the information ratio?
The Information Ratio (IR) measures the performance of a financial asset or investment portfolio against a specific benchmark while considering risk adjustments. It underscores not only the magnitude of excess returns above that benchmark but also their consistency.
Investors, fund managers, and analysts can leverage IR to assess management prowess within mutual funds and hedge funds by comparing how well investment portfolios are doing relative to benchmarks.
Importantly, an elevated IR signifies not merely enhanced returns, but also implies a more significant active return for each unit of risk assumed—indicative of superior managerial skill.
Information Ratio Calculator
How is it Calculated? The formula that our Information Ratio Calculator uses is straightforward:
Information Ratio = (Mean Return of Investment – Mean Return of Benchmark) / Standard Deviation of Residuals
- Mean Return of Investment: This represents the average return generated by the investment over a specific period.
- Mean Return of Benchmark: This denotes the average return of a chosen benchmark over the same period.
- Standard Deviation of Residuals: This measures the volatility or risk of the investment strategy, specifically the differences (residuals) between the investment returns and the benchmark returns.
Using the Information Ratio Calculator In the provided calculator, you can input the mean return of your investment, the mean return of your chosen benchmark, and the standard deviation of residuals. Once you hit the “Calculate” button, the Information Ratio will be computed for you. A higher Information Ratio typically indicates better risk-adjusted performance.
Interpreting the Results from the Information Ratio Calculator A positive Information Ratio suggests that the investment outperformed the benchmark after adjusting for risk, indicating skillful management or superior strategy. Conversely, a negative Information Ratio implies underperformance compared to the benchmark on a risk-adjusted basis.
How to calculate the information ratio?
To calculate the IR, calculate the portfolio return for a given period. Then, subtract the benchmark index return from the portfolio return to find the excess return. Calculating the Information Ratio (IR) may initially seem intimidating, but it becomes straightforward once the involved components are understood.
Next, you need to calculate the tracking error—the standard deviation of the excess return. You can do this by taking the standard deviation between the portfolio and index returns.
Once you have the tracking error, divide the excess return by it to get the Information Ratio. If you want to express the IR as a percentage, multiply the result by 100. The goal is to generate excess returns relative to the benchmark while maintaining a low tracking error.
What is the information ratio formula?
The Information Ratio (IR) formula is as follows: IR = (Portfolio Return Benchmark Return) / Tracking Error.
This is the formula:
- “Portfolio Return” signifies the return of the portfolio for the period being considered
- “Benchmark Return” is the return on the fund or index used as a benchmark for comparison with the portfolio
- The “Tracking Error” measure is calculated as the standard deviation of the variance between the portfolio returns and the benchmark returns. It demonstrates the consistency of the portfolio’s performance compared to the benchmark.
To apply the formula, follow these steps:
- Determine the portfolio return for a specific period.
- Subtract the return of the tracked benchmark index from the portfolio return.
- Divide the resulting figure by the tracking error to obtain the Information Ratio.
- To express the IR as a percentage, multiply the result by 100.
What Information Ratio is good?
Generally, an information ratio of 0.5 or higher is considered good, indicating that the portfolio manager provides some excess return relative to the benchmark. Information ratios of 1 and above are considered excellent and signify that the portfolio manager has delivered returns well above the benchmark, adjusting for the risk taken.
Nevertheless, one must remember that an IR represents more than a mere numerical value; it’s a backward-looking indicator. It does not predict future returns. Also, it must be considered in conjunction with the fund manager’s overall strategy and the market conditions.
What is the difference between Information Ratio and Sortino Ratio?
The difference between the Information Ratio and the Sortino Ratio lies in their approaches to measuring risk. The Information Ratio assesses risk by comparing a portfolio’s excess return to its tracking error, while the Sortino Ratio evaluates risk based on downside deviation from the mean return.
Although the Information Ratio (IR) and Sortino Ratio are both tools for measuring risk-adjusted performance, they serve different purposes:
The IR assesses a portfolio’s excess return relative to its benchmark as well as the inconsistency of these additional gains. This makes it useful for assessing how much extra value a portfolio adds compared to its benchmark in light of fluctuating returns.
Conversely, the Sortino Ratio specifically targets downside volatility and only penalizes those returns that fall short of an established minimum or desired rate of return.
Whereas the IR accounts for fluctuations above and below a given benchmark when considering risk-adjusted performance, the Sortino ratio focuses exclusively on negative deviations from a specified acceptable rate of return.
As such, while investors may use the IR effectively to judge how skillfully a portfolio manager is performing relative to market benchmarks, individuals more concerned with mitigating loss might find greater utility in using the Sortino Ratio due to its emphasis on safeguarding against unfavorable downturns in investment value.
Why is Information Ratio better than Sharpe Ratio?
The Information Ratio is better because it evaluates a portfolio manager’s ability to generate excess returns beyond a benchmark, providing a more targeted assessment of skill than the Sharpe ratio, which focuses on total returns relative to total risk.
Because of its approach to benchmarks, the Information Ratio (IR) is often favored over the Sharpe Ratio for appraising investment performance and risk-adjusted returns. The IR assesses an investment’s active return against a benchmark index and takes into account the volatility of that active return. In contrast, the Sharpe ratio uses the risk-free rate as its reference point.
Investors typically opt for the Information Ratio due to higher market returns compared to risk-free returns. This makes comparisons more pertinent when evaluating an investment’s performance. Part of what comprises calculating IR is tracking error—a measure that sheds light on both fluctuation levels and risks involved in attaining excess returns—something not expressly accounted for by measuring with just the Sharpe ratio.
Can Information Ratio be negative?
Yes, an Information Ratio (IR) can be negative. This outcome suggests that a portfolio manager or investment strategy is failing to produce adequate returns relative to the level of risk incurred and is falling short when compared against a benchmark.
A negative IR reflects a portfolio’s shortfall in surpassing its reference index, highlighting an irregularity in attaining excess returns. The severity of this negative Information Ratio offers stakeholders perspective on how much performance lags behind that benchmark.
What is a bad Information Ratio?
A bad Information Ratio is:
- A low IR value, indicating less than desirable consistency in investment performance
- An IR below 0.4 which can be viewed as less favorable or poor
- A negative IR signifies poor performance as it indicates that the investment’s returns are below the benchmark.
However, while a low or negative IR can be a red flag, you must understand the reasons behind it. It could also signal the wrong benchmark or high volatility of the portfolio.
Does leverage increase Information Ratio?
Leverage does increase Information Ratio in the following ways:
- It affects the active return and active risk differently, potentially altering the IR.
- Adding leverage to a portfolio can increase its active risk more than its active return.
- This could lead to a decrease in the IR.
However, the impact of leverage on performance metrics like the IR ultimately depends on whether the invested capital earns more than the cost of the debt used for financing.
What is the difference between Information Ratio and Treynor Ratio?
The difference between the Information Ratio and Treynor Ratio lies in their assessment of risk-adjusted returns. The Information Ratio compares returns to a benchmark, while the Treynor Ratio measures returns relative to systematic risk, represented by beta.
While both the Information Ratio and the Treynor Ratio are important metrics in investment analysis, they fulfill different roles. The IR evaluates the skill of a portfolio manager at generating consistent excess returns relative to a benchmark, whereas the Treynor Ratio assesses a portfolio’s performance based on systematic risk.
The IR uses the portfolio’s return compared to the benchmark return, whereas the Treynor Ratio compares the portfolio’s return to the risk-free rate. While the IR is useful for analyzing the performance of active portfolio management, the Treynor Ratio is more relevant for portfolios exposed to market risk. It is often used to compare the performance of different investment portfolios or mutual funds.
What is the difference between the IR and the Sharpe Ratio?
The difference between the IR (Information Ratio) and the Sharpe Ratio lies in the types of risks they account for. The Information Ratio evaluates a manager’s ability to outperform a benchmark, while the Sharpe Ratio assesses an investment’s return relative to its overall volatility.
Although the Information Ratio and the Sharpe Ratio are both used to gauge risk-adjusted returns, they have some key differences. The IR measures risk-adjusted portfolio returns above a benchmark’s returns about the volatility of those returns. At the same time, the Sharpe Ratio compares an asset’s return to the risk-free rate of return, adjusted for the asset’s volatility.
The IR calculates the excess returns of a portfolio over a benchmark index and incorporates a tracking error or standard deviation into the calculation. At the same time, the Sharpe Ratio uses the risk-free rate as a comparison point instead of a benchmark index. This makes the IR particularly relevant for investors comparing investment performance to market returns.
What are the limitations of Using the Information Ratio (IR)?
The limitations of using the Information Ratio (IR) include its reliance on historical data, sensitivity to outliers, and potential biases from benchmark selection.
While the Information Ratio (IR) is a helpful tool, it does come with certain constraints. For example, the IR may not be fully appropriate for comparing two portfolios that differ in their compositions, asset allocations, specific securities included, and the timing of their investments – variances that could influence the fairness of comparison. It could compare apples to oranges. Relying on past performance to gauge a portfolio’s IR can be misleading. Historical success reflected by a high IR doesn’t ensure similar results moving forward.
When applying the Information Ratio, the underlying assumption is that excess returns are linearly related to tracking error, a simplification might not always hold true, given market complexities. Employing this ratio alone offers incomplete insight as it neglects various investment strategy risks, such as liquidity or systemic risk factors.
What Is a Good Information Ratio Range?
A Good Information Ratio Range typically falls between 0.5 to 1.0 or higher. Typically, investors prefer a higher positive Information Ratio in the range of 0.4 to 0.6, with a value above 0.6 considered excellent. An IR of 0.5 or higher is generally regarded as acceptable, indicating that the portfolio manager provides some excess return relative to the benchmark.
What is the difference between Information Ratio and tracking error?
The difference between the Information Ratio and tracking error lies in their focus and calculation. The Information Ratio evaluates the risk-adjusted return of an investment relative to a benchmark, emphasizing the quality of returns. In contrast, tracking error quantifies the volatility of returns relative to the benchmark, highlighting the consistency of performance.
Both Information Ratio and tracking error play crucial roles in evaluating portfolio performance, yet they serve different purposes. While the IR gauges an investment’s active return against a benchmark index, considering the volatility of that active return, the Tracking Error denotes the standard deviation of the active return itself.
The IR formula uses tracking error as the denominator, quantifying the risk taken to track benchmark performance. On the other hand, the IR evaluates a portfolio manager’s skill in generating consistent excess returns relative to a benchmark, considering consistency of performance.
What are the pros and cons of Information Ratio?
Pros of Information Ratio: The Information Ratio helps investors assess the risk-adjusted performance of an investment strategy by comparing returns to a benchmark. Cons of Information Ratio: However, it can be sensitive to the choice of benchmark and may not adequately capture tail risks or extreme events in the investment strategy.
Similar to other financial metrics, the Information Ratio has its unique set of advantages and disadvantages. On the upside, the IR allows for:
- Comparison of the performance of various portfolios, accounting for the risk of active management
- Insights into the consistency of a manager’s ability to generate excess returns
- Aiding decision-making regarding manager selection and asset allocation.
However, the IR also has its downsides. It may encourage short-term performance chasing, leading to higher turnover and transaction costs. It assumes a linear relationship between excess returns and tracking error, which may not always reflect the complexities of the market. And while a high IR does not guarantee future performance, it can be misleading if not interpreted considering the investment strategy and market conditions.
Some of the downsides of the IR include:
- Encouraging short-term performance-chasing
- Assuming a linear relationship between excess returns and tracking error
- Not guaranteeing future performance
- Being misleading if not interpreted with consideration of the investment strategy and market conditions.
Does the Information Ratio consider absolute returns or relative returns?
The Information Ratio (IR) considers relative returns, not absolute returns, indicating that it is concerned with relative rather than absolute performance. This ratio assesses how effectively a portfolio manager can deliver excess returns over a specific market or sector index by concentrating on comparative outperformance.
Is the Information Ratio more useful for short-term or long-term investment strategies?
In general, the Information Ratio is more useful for short-term investment strategies. The Information Ratio (IR) is particularly effective for evaluating short-term investments because of its responsiveness to quick market changes. Over longer periods, though, the IR’s emphasis on the volatility of excess returns in a brief timeframe might not give an accurate picture of performance.
Nevertheless, investors leverage the IR to distinguish between transient good fortune and enduring proficiency—an essential distinction when looking at long-term outcomes. This measure provides insight into how adept portfolio managers can produce consistent excess returns compared to a benchmark, underscoring its importance across various investment strategies regardless of their time horizon.
Summary
In the dynamic world of investing, the Information Ratio serves as a valuable yardstick for evaluating the performance of portfolios and fund managers. By measuring a portfolio’s excess return over a benchmark and capturing the consistency of these excess returns, the IR provides investors with a deeper understanding of potential risks and returns.
While the IR has its limitations and should not be used in isolation, it remains a critical part of a robust investment analysis toolkit. Understanding the Information Ratio can help you make informed decisions and maximize your investment performance, whether you’re a seasoned investor or just starting your investment journey.
