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Information Ratio

The information Ratio (IR), also known as appraisal ratio is a measurement of returns of asset or portfolio investment. It shows the consistency of the fund manager in generating risk-adjusted performance of the portfolio. A higher information ratio indicates that the fund manager has outperformed and has delivered consistent returns over a period of time.

The information ratio is useful while comparing a group of funds with similar management styles. The ratio is calculated by dividing the active/actual return of the portfolio by the tracking error. A tracking error helps to identify the level of consistency in which the portfolio tracks the index performance. A low tracking error represents an index-beating portfolio whereas a high tracking error means that the portfolio returns are volatile and not consistent in exceeding the existing benchmark.

The information ratio can tell you the expertise and reliability of the fund manager in minimising risk and performing above the benchmark.

How is the Information Ratio Calculated?

The information ratio of an investment or mutual fund portfolio is calculated using the following formula.

Information ratio = (R-BR)/w Where,

  • R = Portfolio/investment returns
  • BR = Benchmark returns
  • (R-BR) = Active returns of the investment/portfolio
  • W = Standard deviation of the active returns or tracking error of the scheme Follow the below-listed steps to calculate the information ratio.
  • Step 1: Take per day or month returns of your mutual fund portfolio and the benchmark for a certain period.
  • Step 2: Take the difference between the returns and the benchmark. Check whether the difference is positive or negative to reveal the performance.
  • Step 3: Calculate the average of the difference for the entire period.
  • Step 4: Divide the actual returns over the benchmark by the volatility of the returns. The number that you will get is an information ratio for a particular fund.

A higher information ratio is always better and indicates higher actual returns and vice versa.

Benefits of Information Ratio in Mutual Fund

Here are the reasons why you should rely on information ratio while comparing a group of funds and measuring the effectiveness of your portfolio.

  • Information ratio is an advanced method to measure the fund's relative performance to its benchmark. It doesn't merely measure and compare returns but also adjusts the results according to the volatility of the market.
  • Information ratio tells you how much excess return is generated from the amount of excess risk taken and its relativeness to the benchmark.
  • Unlike Sharp ratio, IR doesn't only reveal how much compensation you get for the risk taken but also indicates how much the asset manager yielded by benchmark deviation.
  • Information ratio helps you to compare the returns at different points in time where the entry and exit don't impact the performance.
  • It helps to identify a more reliable and better-performing asset that will give you a good and consistent experience investing in mutual funds.
  • Investors who are interested in small-cap and mid-cap mutual funds, information ratio, helps them to analyse the contextual risks and past performance of the funds.

Information Ratio Formula Outcome Analysis

A higher information ratio indicates a positive outcome and vice versa. If your mutual fund earns a better average excess return over lower deviation, then it is performing well. It is important to note that the information ratio depends on the tenure that you consider while calculating. If the benchmark is higher than the average, it indicates a negative information ratio and poor portfolio performance. Additionally, we compare ratio with the baseline, so changing benchmark will lead to a change in the ratio of the mutual fund scheme. Information ratio considers only mathematic average without considering compounding returns. This is a flaw of IR which may mislead investors if they are not aware of this and do not use any other portfolio measurement tool. Sometimes, even a negative ratio can exceed the benchmark or a mutual fund with higher IR. It is essential not to consider active returns vs benchmark alone. Look for consistency of the ratio over a period of time.

Moreover, the information ratio is based on historical data and performance and does not guarantee that similar performance will be maintained in the future.

Information Ratio and Mutual Fund Portfolio

The information ratio is often used to determine the skill of mutual fund managers. The ratio measures the expected returns of the manager's portfolio concerning the amount of risk the fund manager takes.

A high IR is a result of a high rate of return of your mutual fund portfolio. A high IR means that a fund manager has produced better returns on a risk-adjusted basis compared to the index benchmark. The index comparison makes IR more appealing to investors because index funds are generally the benchmark used while comparing investment performance and the returns are usually higher than the risk-free returns.

FAQs on Information Ratio for Mutual Funds

Why is IR a Reliable Tool to Help You Choose the Best Mutual Fund?

Information Ratio (IR) is a more practical and accurate measurement tool to compare portfolio returns and benchmark and also to adjust the results as per the market volatility.

Do you want a high or low information ratio?

A high information ratio indicates positive outcome whereas low information ratio suggests that the fund manager is unable to perform as per the set benchmark. It is always good to have a high information ratio.

How do you calculate the Treynor ratio?

Treynor ratio can be calculated by using the following formula: Treynor ratio = (Rp-Rf)/B Where,

Rp = Returns generated by portfolio Rf = Risk-free rate B = Beta which represents the sensitivity of the portfolio towards movements of the benchmark

How important is the Sharpe ratio?

The sharp ratio is used to measure the performance of the fund. It gives you the exact information on which mutual fund is performing the best among the options available.

How is the active share calculated?

Active share is determined by taking the sum of absolute value of weight differences of each holding in the fund manager's portfolio and the weight of each holding in the benchmark index and dividing the same by two.

How is stock volatility measured?

Follow the below-listed steps to calculate stock volatility.

  • Step 1: Calculate an average price for the number of periods
  • Step 2: Determine deviation for each period
  • Step 3: Square each period’s deviation
  • Step 4: Take sum of the squared differences
  • Step 5: Divide the square deviation sum by the number of periods/observations

How is the batting average calculated?

The batting average is calculated as the number of hits divided by at-bats. It is generally reported to three decimal places and read without the decimal.

What does a high tracking error mean?

Tracking error is a difference between a portfolio’s return and the benchmark it was meant to beat. A high tracking error indicates that portfolio returns are volatile and not consistent.

What does a negative Sharpe ratio mean?

A negative sharp ratio either means the risk-free rate is higher than the mutual fund portfolio's return or the portfolio's return is expected to be negative.

What does the information ratio measure?

The information ratio (IR) measured the risk-adjusted return of an asset or portfolio. In the case of a mutual fund, IR measures the active return of the manager's portfolio with respect to the benchmark.

What does the information ratio tell you?

The information ratio measures the return and risk concerning a specific benchmark. A low information ratio means that the fund manager is unable to produce excess returns and vice versa. Investors should not invest in a mutual fund with an information ratio as low as 0.4. If IR is between 0.4 and 0.6, it is considered to be a decent choice to invest, and IR above 0.6 is viewed as a great investment.

What does the Sortino ratio mean?

A Sortino ratio is a tool to measure the performance of a mutual fund. It measures the risk-adjusted returns of the fund or an investment asset.

What is a good information ratio for a mutual fund?

Information ratio between 0.4 and 0.6 is considered good. Anything above 0.6 is considered a great IR.

What is an active return?

Active return is a return (gain or loss) on investment with respect to the investment’s benchmark.

What is the average Sharpe ratio?

A sharp ratio is a well-known tool to measure risk-adjusted return on investment. Generally, a sharp ratio greater than one is considered average and acceptable.

What is beta in a mutual fund?

Beta in mutual fund represents the sensitivity of the portfolio towards the movements of the investment’s benchmark.

What is financial information ratio?

A financial information ratio which is also known as appraisal ratio, is a tool to measure the risk-adjusted returns and the performance of fund manager in a mutual fund portfolio.

What is M Squared in finance?

The M-Squared, also known as Modigliani risk-adjusted performance is a tool to measure the risk-adjusted returns of portfolio investments.

What is the Sortino ratio in mutual funds?

Sortino ratio is a statistical tool to calculate and measure the performance of mutual fund investment. It focuses explicitly on downside volatility of a mutual fund scheme.

What is the difference between the Sharpe ratio and the information ratio?

The sharp ratio is a measure that indicates the average portfolio return minus the risk-free return divided by the SD (Standard Deviation) of ROI. It is a tool to measure risk-adjusted returns. The higher sharp ratio indicates better performance of the fund. Information ratio (IR) is a ratio of returns on the portfolio above the benchmark returns (usually index returns). IR measures the fund manager’s ability to generate excess returns with respect to the benchmark. It also identifies the consistency of the investor and the amount of an extra risk taken to beat the benchmark.

What is the Sharpe ratio in a mutual fund?

The sharp ratio is one of the essential tools to measure the performance of a mutual fund. With the help of sharp ratio, an investor can determine whether the fund meets his/her requirements or not.

What is a tracking error in a mutual fund?

Tracking error is the difference between a mutual fund’s return and the index benchmark it was designed to beat. Usually, tracking error is calculated against the total returns for a specific benchmark that also includes dividend payments and is also reported as a "Standard deviation percentage" difference.