Definition
The Information Ratio (IR) is a financial term that quantifies the potential reward obtained for the level of risk taken. It gauges a portfolio manager’s ability to exceed the returns of a benchmark, compared to the volatility of those returns. A higher Information Ratio indicates consistent high return and efficient risk management by the portfolio manager.
Key Takeaways
- The Information Ratio (IR) is a financial measure used to evaluate the performance of a portfolio against a specific benchmark. It measures the risk-adjusted return of a financial portfolio, meaning it assesses how much more return an investment manager has made with a portfolio compared to a certain benchmark but adjusted for risk taken.
- To calculate the Information Ratio, the portfolio return rate is subtracted from the benchmark return rate. This is known as the active return. Then, the active return is divided by the tracking error, which is the standard deviation of the active return.
- A higher Information Ratio indicates a greater risk-adjusted return in comparison to the benchmark. This implies that the portfolio manager attained superior returns compared to the benchmark while assuming a similar level of risk. However, a lower IR might indicate underperformance. It’s crucial to remember that this ratio should not be utilized in isolation but should be complemented with other investment metrics and considerations.
Importance
The Information Ratio (IR) is an important financial term because it measures the risk-adjusted return of a financial portfolio or an investment manager.
It quantifies the potential level of expected returns over and above what the benchmark returns are for each unit of risk taken.
By doing this, the IR lets investors understand the efficiency and skill of a portfolio manager in generating excess returns while taking into consideration the risks involved.
Hence, a higher IR indicates better risk-adjusted performance and a more superior skill in trading or investing, which assists investors in comparing and selecting investment managers or portfolios.
Strip away the jargon, it’s a snapshot of a fund’s performance and a quick way to see if it’s beating its market benchmark.
Explanation
The Information Ratio serves as a pivotal performance measurement tool for evaluating the skill of a portfolio manager. It calculates the amount of active return per each unit of risk, with an aim to offer insights into the efficiency of the portfolio’s diversifications and risk management strategies.
Notably, its purpose isn’t just to assess the raw returns earned by a portfolio but also, and more essentially, to understand how much additional risk was undertaken to generate that return. Higher information ratios indicate more successful strategies and a better return on investment per unit of additional risk.
For portfolio managers and investors, the Information Ratio serves as a metric to estimate the success of investment decisions and strategies by taking risk into account. For instance, two portfolios with similar annual returns might appear identical in terms of success, but the information ratio could reveal which portfolio manager has more efficiently balanced risk and return.
Therefore, the Information Ratio is a critical tool in the world of finance for making informed decisions, managing risk, and ultimately enhancing the productivity and efficiency of investment strategies.
Examples of Information Ratio
**Mutual Fund Performance**: The Information Ratio (IR) is often used in evaluating the performance of mutual funds. For example, a mutual fund may have an annual return of 15%, however, the benchmark index may have an annual return of 10%. The excess return of the fund is therefore 5%. Suppose the standard deviation of this excess return (tracking error) is 2%. Thus, the IR of this mutual fund would be 5% / 2% =This shows the mutual fund has a higher information ratio and therefore, a better performance relative to the risk taken than the benchmark.
**Portfolio Management**: A portfolio manager may track the IR to ascertain the efficiency of their investment strategy. For instance, if a manager consistently outperforms the relevant benchmark with an IR of8, and later the IR drops to
3, it may suggest that their investment strategy isn’t working as effectively, prompting them to reassess their approach.**Hedge Fund Evaluation**: Hedge funds typically strive for positive absolute returns rather than outperforming a specific market benchmark. However, the IR can still be applicable for comparing different hedge funds or comparing a hedge fund with a relevant index. If Hedge fund A has an IR of 2 and Hedge fund B has an IR of
5, it can be interpreted that fund A gets more return for each unit of risk it takes compared to fund B, making it more attractive to potential investors.
FAQ on Information Ratio
What is the Information Ratio?
The Information Ratio (IR) is a financial measure that quantifies the amount of active return a fund manager or investor is gaining for the level of transactions they are taking, compared to the market’s benchmark. It is calculated by taking the active return (subtract the benchmark’s return from the portfolio’s return) and dividing it by the tracking error.
Why is the Information Ratio important?
The Information Ratio allows investors to assess the skill of a fund or portfolio manager. An investor can compare the IRs of different funds or portfolios to make investment decisions. The higher the IR, the more return the fund is getting for its risk. Therefore, a fund with a higher IR is believed to be managed better than a fund with a lower IR.
How can I calculate the Information Ratio?
The Information Ratio is calculated by subtracting the benchmark return from the portfolio return, which gives the active return. The active return is then divided by the tracking error (standard deviation of active returns) to get the Information Ratio. Therefore, the formula is: IR = (Portfolio Return – Benchmark Return) / Tracking Error.
What is considered a good Information Ratio?
Generally, an Information Ratio above 0.5 is considered good, above 0.75 is very good, and above 1.0 is excellent. This suggests that the portfolio returns exceed the benchmark returns by 50%, 75%, and 100% per unit of risk, respectively.
What is the difference between Information Ratio and Sharpe Ratio?
The Sharpe Ratio also measures risk-adjusted returns, but it compares the portfolio’s excess return (over the risk-free rate) to its standard deviation, while the Information Ratio compares the portfolio’s active return (over a benchmark) to its tracking error (standard deviation of the active returns).
Related Entrepreneurship Terms
- Alpha
- Benchmark
- Risk-adjusted return
- Standard deviation
- Tracking error
Sources for More Information
- Investopedia: A comprehensive resource for all things related to finance and investing, including in-depth articles on a variety of topics including the Information Ratio.
- Morningstar: Widely regarded as a reliable source of information on investment tools and strategies, including the Information Ratio.
- The Balance: A personal finance website that offers practical advice and resources on personal investing, including the information ratio.
- CFA Institute: A global, professional organization of investment professionals, provides educational materials and resources like the information ratio.
