Key Takeaways
- Measures risk-adjusted excess returns versus benchmark.
- High ratio indicates consistent outperformance with low volatility.
- Focuses on active risk, not total portfolio risk.
What is Information Ratio?
The Information Ratio (IR) measures a portfolio's risk-adjusted excess returns relative to a benchmark, calculated by dividing the difference between portfolio and benchmark returns by the tracking error. This metric helps you evaluate how consistently a fund outperforms a chosen index, focusing on active risk rather than total volatility.
By comparing a portfolio’s performance to a benchmark like the S&P 500 or ETFs such as SPY and IVV, the Information Ratio offers insight into manager skill beyond simple returns.
Key Characteristics
Understanding the core traits of the Information Ratio helps in analyzing active portfolio management effectively.
- Risk-Adjusted Measure: Assesses excess returns relative to benchmark volatility, unlike the Sharpe ratio which uses total risk.
- Tracking Error: The denominator reflects the standard deviation of active returns, capturing consistency in outperformance.
- Benchmark Dependency: Accuracy depends on the appropriate selection of a relevant reference index or fund.
- Interpretation: IR above 0.5 indicates strong, consistent active management; values near zero suggest performance matches the benchmark.
- Complementary Metrics: Often analyzed alongside Jensen’s Measure and models like the Fama and French Three Factor Model for a full performance assessment.
How It Works
The Information Ratio quantifies how much excess return a portfolio generates per unit of active risk relative to a benchmark. You calculate it by subtracting the benchmark return from the portfolio return, then dividing by the tracking error, which measures the volatility of that difference.
For example, if a portfolio returns 12% while the benchmark returns 8%, and the tracking error is 5%, the IR is 0.8, signaling consistent outperformance. This makes IR particularly useful for evaluating active funds compared to low-cost index funds found in best low-cost index funds or ETFs like those listed in best ETFs.
Examples and Use Cases
Investors and fund managers use the Information Ratio in various scenarios to gauge performance quality and consistency.
- Equity Funds: Actively managed funds aim to achieve a high IR by outperforming benchmarks such as the S&P 500 or ETFs like SPY.
- Airlines: Companies like Delta and American Airlines may be analyzed by investors considering relative performance against industry benchmarks.
- Portfolio Selection: Investors use IR to differentiate skilled active managers from passive strategies, complementing analyses with measures like abnormal returns.
Important Considerations
While the Information Ratio provides valuable insight into active performance, it relies heavily on the choice of benchmark, which can bias results if not aligned with the portfolio's investment style. Short-term IR values may be misleading, so a multi-year perspective is recommended.
Additionally, IR does not account for total portfolio risk, so you should consider it alongside other metrics such as discounted cash flow analyses or immunization strategies to build a comprehensive investment view.
Final Words
The Information Ratio reveals how consistently a portfolio outperforms its benchmark relative to the risk taken. To apply this insight, compare the IR of funds you're considering to identify managers delivering reliable excess returns with controlled active risk.
Frequently Asked Questions
Information Ratio (IR) measures a portfolio's risk-adjusted excess returns compared to a benchmark, calculated by dividing the difference between portfolio and benchmark returns by the tracking error. It helps evaluate how consistently a manager outperforms the benchmark.
The Information Ratio is calculated as (Portfolio Return – Benchmark Return) divided by the Tracking Error, which is the standard deviation of the excess returns. For example, if a portfolio returns 12%, the benchmark 8%, and tracking error is 5%, the IR is 0.8.
A high Information Ratio, typically above 0.5, indicates that a portfolio consistently delivers excess returns with relatively low volatility compared to its benchmark. This suggests strong active management skill.
The Information Ratio compares portfolio returns to a benchmark and focuses on active risk, while the Sharpe Ratio compares returns to the risk-free rate considering total risk. IR is best for assessing relative performance, Sharpe for absolute risk-adjusted returns.
Tracking error measures the volatility of the difference between portfolio and benchmark returns, reflecting the consistency of outperformance. It is the denominator in the IR formula, so lower tracking error increases the IR if excess returns are positive.
Yes, a negative Information Ratio means the portfolio underperforms its benchmark on a risk-adjusted basis, indicating that the manager is not adding value through active management.
To annualize the Information Ratio from daily returns, multiply the daily IR by the square root of 252, which is the typical number of trading days in a year.
Investors comparing actively managed funds against a benchmark, such as mutual fund or hedge fund investors, benefit from the Information Ratio as it shows how skillfully managers generate consistent excess returns relative to a specific index.
