Information ratio is a strategy-independent performance measure that captures the excess return above a benchmark. In other words, it determines how much an investment outperforms or underperforms its benchmark over a while. The excess return is measured by finding the difference between the actual return and what would have been expected to be earned at every point in time.
Information Ratio is an important aspect when it comes to evaluating an investment’s risk and return. In this article, we will be looking at what Information Ratio is, how to calculate it and how it is different from Sharpe Ratio.
What is the Information Ratio?
The Information Ratio (IR) is a statistic that is used to measure portfolio returns above the returns of a benchmark. It is usually considered as an index such as the S&P 500. The IR calculation compares the volatility of the portfolio returns against the benchmark returns
To put it simply, the Information Ratio is a measurement that showcases how much an investment outperforms (or underperforms) its benchmark when risk is taken into account.
The Information Ratio can also be used to measure the manager’s ability to generate returns over a benchmark, with a higher IR result implying a better portfolio manager.
The importance of Information Ratio
The Information Ratio is an important performance metric because it takes into account both risk and returns. It is a tool that can be used to measure an investment’s volatility and also how it compares to a benchmark. Here are some reasons why Information Ratio is important to consider
- It can be used as a performance measure on its own or compared against other investments
- It helps determine if an investment’s returns are enough for the risk taken
- An investor can track how well their manager is investing by looking at the IR result
- The result helps investors understand if you are overpaying for the performance
How to calculate Information Ratio
Calculation Information Ration is pretty straightforward. Here is the formula for calculating Information Ratio or IR
IR = (Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking Error
Portfolio Rate of Return: The Portfolio Rate of Return is the actual rate of return of the portfolio over a given period.
Benchmark Rate of Returns: The rate of Returns is the rate of return that would have been expected if the investment was put into a benchmark index.
Tracking Error: Tracking Error is the volatility (standard deviation) of the Portfolio Rate of Returns above the Benchmark Rate of Returns.
Example of Information Ratio
Let’s say an investor has a portfolio that earned an annual rate of return of 10% over the past year. The Benchmark Rate of Returns for the same period is 8%. The Tracking Error is 2%.
The calculation for the Information Ratio would be: (10% – 8%) / 2% = 1.0
This means that the investor’s portfolio outperformed the Benchmark Index by 1% and this outperformance was due to the portfolio’s volatility being lower than the benchmark.
Let’s take a look at another one, where the portfolio underperformed its benchmark. Let’s say an investor has a portfolio with a rate of return of 7% and the Benchmark Rate of Return for this period is 8%. The Tracking Error here is 1%.
The calculation for Information Ratio would be: (7%-8%) / 1% = -0.14
In this case, the portfolio’s returns are below that of the Benchmark Index. The investor would have been better off investing in a benchmark index as there is very little outperformance due to the higher volatility.
Information Ratio Vs Sharpe Ratio
Sharpe Ratio is a statistical measure used to determine the return per unit of risk for an investment. The ratio was developed by William Sharpe, who received the Nobel Memorial Prize in Economic Sciences.
To put it simply, Sharpe Ratio is used to compare how risky one portfolio’s returns are against another portfolio with lower returns and less risk taken.
- Information Ratio is a strategy-independent measurement that tracks the excess returns of a portfolio above a benchmark while Sharpe Ratio is used to measure a portfolio’s risk-adjusted performance.
- The two ratios are both strategies for avoiding risk and earning higher returns, but they calculate things differently.
- They have different weaknesses in understanding an investment because Sharpe Ratio doesn’t account for the benchmark index whereas Information Ratio does.
- Information Ratio is more accurate because it takes into account how much risk was taken to generate returns. On the other hand, the Sharpe Ratio measures only one side of volatility without considering an excess return.
So now you know what Information Ratio is. It’s important to know why it is useful because this will help you understand how it can be applied. It can be really important to use the ratio in different situations. One is when you are comparing investments and another is to track how a portfolio manager is performing. It’s a good statistic to be aware of in your investment journey.