What Is Information Ratio?
A gauge of managers' skill
It is used to gauge the skill of managers of funds. The manager's portfolio is divided by the amount of risk that the manager takes relative to the benchmark to calculate the active return. The higher the information ratio, the better the portfolio's active return.
The Information Ratio: An Indicator of Risk-Adjustes Return
The IR is a measure of a portfolio manager's skill and ability to generate excess returns relative to a benchmark, but it also attempts to identify the consistency of the performance by incorporating a tracking error into the calculation. The level of consistency in which a portfolio tracks the performance of an index is identified by the tracking error. The portfolio is beating the index consistently.
A high tracking error means that the portfolio returns are more volatile and not as consistent as the benchmark. The standard deviation of the difference between the portfolio returns and the index returns can be used to calculate the tracking error. The standard deviation can be calculated using a financial calculator.
The standard deviation of the returns between a portfolio and the benchmark index is used to calculate the tracking error. Standard deviation is a measure of risk associated with an investment. A high standard deviation means there is more variability.
The information ratio helps to determine how much a portfolio trades in excess of its benchmark but also how much risk it poses. With the fees being charged by active fund managers, more investors are turning to passive funds that track benchmark indexes. Some investors pay a small fee for an actively managed fund.
It's important to know if the fund is beating the benchmark index on a consistent basis. The IR calculation can help you understand how well your fund is being managed. The information ratio is a good indicator of risk-adjusted returns.
Information and Sharpe Ratios
The information and the Sharpe ratios are similar. Risk-adjusted returns of a security or portfolio are determined by the ratios. The information ratio and the Sharpe ratio compare the risk-adjusted returns to the risk-free rate.
The IR of the Manager
The higher the IR, the better. The manager did not succeed in beating the benchmark if the IR is negative. It is not easy to out perform the benchmark. IR between 0.4 to 0.6 is usually good.
An Example of a Portfolio Manager
Let's say you have some money that you want to invest in the market. You have two funds in which you want to invest, but you are confused about which one to invest in. You will compare the information ratio of the funds.
You have used the S&P 500 index as a benchmark. There are two investment strategies that investors can use. An investor tries to beat the benchmark and get return over and above benchmark returns.
In passive management, investors try to mimic the performance of the benchmark or invest in it. Portfolio managers who use active management strategy have to put in a lot of work. They charge a lot of fees for management.
High Information Ratio in Managed Accounts
The higher the information ratio, the better. The first objective of the active manager is to beat the benchmark. The information ratio is one of the most difficult hurdles to clear.
The information ratio in the range of 0.40-0.60 is considered quite good. Information ratios of 1.00 are very rare. The excess return over the benchmark is displayed in the top graph.
The benchmark is the thick black line, and the red and blue lines show excess returns for two different managers. The bottom graph shows the tracking error versus the benchmark. The larger the tracking error, the more consistent the excess returns.
There are ranges of 10-year information ratios. Peer groups of managed account composites are compared to their benchmark. The high information ratio is difficult to achieve.
The median manager has an information ratio that is close to zero. Managers with information ratios in excess of 1.00 are rare. The information ratio is easy to calculate.