Information Ratio

Information ratio measures success of an active investment management strategy/fund by comparing the excess returns earned by the investment portfolio to the volatility of those excess returns. It is calculated by dividing excess returns of an investment portfolio (which equals portfolio return minus return on the relevant benchmark) by the standard deviation of those excess returns.

In managing their investments, investors can adopt either the active management approach or passive management approach. In active management, an investor attempts to beat other investors in the market by picking stocks and timing their purchase and sale. On the other hand, some investors who opt for passive investment management, believe that the effort needed in attempting to beat the market is too much relative to the probability of beating the market. Hence, they go with the market and invest in an index representing the broad market such as S&P 500 or an index representing an investment class or industry, etc. Since active manager charge hefty fees for management of assets, it is important to keep track of excess return and the degree to which the excess return is generated by their investment acumen and not pure chance.

Formula

Information Ratio =Portfolio Return – Benchmark Return
Tracking Error

Portfolio return is the aggregate return on the portfolio for a period.

Benchmark return is the return on an index which represents the investment space in which the investor is attempting to generate excess returns. It is the return which a passive investor can earn without attempting to beat the market.

Tracking error measures the consistency with which an investor has generated excess returns. It is measured by the standard deviation of excess returns. Tracking error is low if an investor consistently earns excess returns and it is high when the excess returns are random and inconsistent.

Higher information ratio is always better because it shows that the excess return is consistent.

Information ratio vs Sharpe ratio

Information ratio is similar to Sharpe ratio, which is another measure of risk-adjusted return. However, there are two differences: (a) while information ratio measures excess return relative to a benchmark, Sharpe ratio calculates excess returns with reference to a risk-free rate and (b) the measure of risk used in information ratio is the standard deviation of excess returns, but in case of Sharpe ratio, risk is defined as the standard deviation of portfolio returns instead of the standard deviation of returns in excess of the risk free rate.

Example

Secure Alpha is the flagship large-cap equity mutual fund of Alligator Asset Management. Following is the monthly return for the fund and its benchmark, a broad-market index, for the latest year:

Secure AlphaBenchmarkExcess Return
January0.50%0.50%0.00%
February1.20%0.80%0.40%
March0.50%0.75%-0.25%
April-0.10%-0.05%-0.05%
May-0.20%-0.30%0.10%
June0.60%0.25%0.35%
July1.20%1.00%0.20%
August0.50%-0.05%0.55%
September-0.20%0.20%-0.40%
October0.90%0.80%0.10%
November1.10%1.20%-0.10%
December1.30%1.20%0.10%

The annual return for the fund and benchmark works out to 7.53% and 6.47% respectively.

Using MS Excel STDEV function, we can find out that the standard deviation of the excess return is 0.27%

Using this information we can find out that the information ratio for the fund is 3.92 [=(7.53% - 6.47%)/0.27%].

Written by Obaidullah Jan, ACA, CFAhire me at