What Is An Information Ratio?
The information ratio (IR) measures an investment manager’s skill in generating returns above a benchmark or an index while considering the volatility of the returns. It compares the return on investment or portfolio to the returns of a benchmark or an index.
The primary purpose of the information ratio (IR) parameter is to evaluate the investment manager‘s effectiveness in producing returns that surpass the benchmark while considering the level of risk taken to achieve those returns. It also demonstrates the portfolio returns’ stability, reflecting its performance over time. In its calculation, another parameter called “tracking error” is used to indicate the risk-adjusted returns of an investment.
Table of contents
- The information ratio measures the risk-adjusted performance of a portfolio relative to a benchmark.
- This ratio is significant because it can help investors understand the skill level of an asset or investment manager and show the consistency of returns over a specific period.
- Typically, investors prefer a higher positive information ratio of 0.4 to 0.6. A value above 0.6 is considered excellent.
- It is considered reliable because it accounts for the volatility of returns.
Information Ratio Explained
The information ratio is an important aspect of investing, wherein the investment manager uses their expertise to generate more returns on investment above the benchmark. Typically, a benchmark such as S&P 500, Nasdaq Composite, etc., is used as a reference point. Before investing, the investor would be aware of the expected return, known as the benchmark return. It is based on the performance of the index over the years, as well as other factors that are considered.
After investing, asset or portfolio returns usually differ from benchmark returns. Ideally, investors expect the portfolio returns to be higher, indicating that they have earned above-average or more-than-expected returns. However, if the benchmark returns are higher, the investment has underperformed, and the investment efficiency is unsatisfactory.
This is where the information ratio comes into play as it measures the portfolio’s performance relative to the benchmark and considers the amount of risk taken to generate those returns. Furthermore, a higher value of the information ratio is generally considered better, indicating better performance and investment efficiency.
Now, let’s look at the information ratio formula:
Here are a few essential points to remember:
- A negative information ratio does not indicate that there are no returns or that the investor makes a loss. The investor can make extremely high returns and still have a negative ratio if the returns exceed the benchmark.
- Different investors have different risk tolerance. Similarly, different securities have a different risk-return values associated with them. Therefore, a one-size-fits-all approach is not recommended in this case.
Refer to the examples below – a simple and real-life calculation.
Here’s a calculation example.
- The benchmark returns from index X in 2022 = 9.3%
- The annualized return from portfolios = 11.2%
- Tracking error = 6.7%
Though the ratio is positive, it is below the 0.4 mark. Therefore, it is neither a good investment nor a bad one.
Recent research shows that the information ratio of 23 equity sectors under the Investment Association has reached its lowest in at least 16 years. The study was conducted from 2007 to 2022, and the IRs of each of these sectors were monitored. Surprisingly, in 2022, the funds showed an average IR of -0.68. This is attributed to the decrease in the efficiency and skills of investment managers.
The best performers are the IA Commodity/ Natural Resources sector with 1.13 and the IA Global Equity Income sector with 0.4. Unfortunately, these are the only two sectors with a positive IR. The worst-performing sector is IA Financials and Financial Innovation, with -1.48.
The second lowest in the study period was -0.42 in 2016. However, the decline was due to the Brexit Referendum and the U.S. Presidential election.
Information Ratio vs Sharpe Ratio
The following table outlines the main differences between the information ratio and the Sharpe ratio:
|Basis||Information Ratio||Sharpe Ratio|
|Purpose||Measures the consistency of returns from an investment manager||Measures the excess returns relative to the risk of an investment|
|Calculation||(Portfolio return – Benchmark return) / Tracking error||(Portfolio return – Risk-free rate) / Standard deviation of returns|
|Secondary Factor||Benchmark return||Risk-free rate|
|Focus||Manager’s skill in outperforming a benchmark||Investment’s return per unit of risk|
|Use||Evaluating the performance of an investment manager||Comparing the performance of different investments|
The information ratio and Sharpe ratios measure risk-adjusted returns, but the information ratio focuses on evaluating an investment manager’s ability to outperform a benchmark. At the same time, the Sharpe ratio looks at an investment’s excess return relative to the amount of risk taken. The secondary factor in the information ratio is the benchmark return, while the Sharpe ratio uses the risk-free rate. Investors can use both ratios to evaluate investment performance, but they are typically used for different purposes.
Frequently Asked Questions (FAQs)
Treynor and information ratios are performance metrics used to evaluate the risk-adjusted return of an investment portfolio. The main difference is that the Treynor ratio measures the excess return earned per unit of systematic risk. In contrast, the information ratio measures the excess return earned per unit of tracking error.
One potential issue is that the method assumes a normal distribution of returns, which may not always be the case in real-world scenarios. In cases where returns are not normally distributed, the information ratio may not accurately reflect the risk-adjusted performance of the strategy. Another issue is that the information ratio only considers the strategy’s relative performance compared to a benchmark and does not consider the strategy’s absolute performance.
The information ratio is a widely used performance measure in the investment management industry. It is commonly used by portfolio managers, investment analysts, and other financial professionals to evaluate the risk-adjusted performance of investment strategies or portfolios. In addition, it is used by both active and passive managers and individual investors to assess the performance of their investments relative to a benchmark.
This has been a guide to what is Information Ratio. Here, we explain it with its comparison with Sharpe Ratio and its examples. You can learn more about accounting from the following articles –