The information ratio (IR) is a metric used to evaluate the performance of an investment manager or portfolio. It measures the ability to generate excess returns above a benchmark index, considering the risk assumed. Let's take a look at how this ratio works, its calculation formula, limitations and more.
Information relationship
The information ratio is the ratio between the “active” profitability of a portfolio in relation to its reference index (benchmark) versus the volatility of this active profitability.
It allows you to evaluate the coherence of a manager and his ability to create long-term value.
The higher the information ratio, the more efficient the administrator will be.
To create value, an active manager uses stock selection and weighting in the fund he manages. You'll select stocks that appear to have the most discounts and avoid those that are more expensive.
Depending on the appreciation potential, the level of risk you are willing to take, or other more qualitative elements (market environment, macroeconomic outlook, etc.), the weighting of stocks and sectors will vary.
Therefore, the manager makes “active” bets, that is, those that stand out more or less clearly from his benchmark index. This can even select values that are not part of this index.
If the manager's decisions are correct, the active return or the return gap of the fund compared to the benchmark index will be significant and the information ratio will increase.
IR Evaluation
However, certain elements can weigh on the information ratio. Therefore, if the manager increases the liquidity of his portfolio, this will decrease his information ratio. The same applies if the manager uses leverage.
Evaluating the information ratio over a sufficiently long investment horizon (5, 10 years) is relatively relevant if only to determine the manager's ability to create value over a complete market cycle.
The information ratio indicates a portfolio manager's ability to outperform the benchmark while remaining faithful to it. The reference point, in this case, usually represents a market or a sector, or even an industry.
Value is used to judge actively managed portfolios. We are talking about those portfolios whose management allows the manager to consciously deviate from the reference index, as would not happen if it were passive management such as that of ETFs.
The Information Ratio is certainly not a predictive value. Rather, it indicates the extent to which a fund outperforms or has outperformed a given benchmark at a given time. Therefore, to calculate its value it is necessary to know a posteriori to what extent the difference has value.
IR Formula and Calculation
The IR is calculated by dividing the difference between the portfolio returns and the benchmark returns (active return) by the standard deviation of these excess returns.
This formula helps evaluate risk-adjusted returns. The calculation of the information ratio is as follows, taking into account that the tracking error is the difference between the volatility of the portfolio and the volatility of the relative reference index:
(Portfolio Return – Benchmark Return)/Tracking Error
What IR can tell you
IR provides insight into a fund manager's efficiency in generating excess returns compared to the benchmark index. A higher IR suggests better performance in managing the investment portfolio.
How to interpret the information ratio? The higher the information ratio, the more efficient the portfolio management will be. More performance compared to the benchmark is achieved with less risk. The bottom quartile of investors and financial managers generally achieve an information ratio of 1.5.
The difference between IR and Sharpe ratio
The information ratio is the best criterion to evaluate an active manager. Of course, it is not the only one, but it can be useful to investors in their fund selection work.
While the Sharpe ratio is used to measure the performance of a portfolio beyond the return on risk-free assets for a given level of risk (how much excess return a fund offers per 1 unit of risk assumed), the Sharpe ratio information no longer takes the risk-free asset as a reference point, but rather the reference point with which the manager is compared.
While both the Sharpe ratio and the information ratio measure risk-adjusted returns, the Sharpe ratio uses the risk-free rate as a benchmark, unlike the IR, which uses a benchmark index.
Limitations on the use of information ratio (IR)
The IR can vary significantly depending on the chosen reference point. It may not always reflect the skill of the investment manager, especially in volatile markets.
Example of how to use this proportion
Fund managers often use IR to compare the performance of mutual funds or hedge funds. It helps make informed investment decisions by analyzing a manager's ability to outperform a benchmark index.
What is a good information ratio range?
A good IR range depends on the market context and the investment strategies used. Generally, a higher IR indicates better performance.
Can an IR be negative?
Yes, an IR can be negative, indicating that the portfolio manager is underperforming the benchmark.
For a detailed exploration of these topics, I recommend consulting financial textbooks or investment strategy resources.
