Ratio analysis is an indispensable practice when dealing in financial markets. Their significance presents itself in almost all decision-making processes in the realm of exchanges, across both ends of the spectrum. Naturally, given the financial market’s complexity, there’s a vast number of such metrics.
Each of these ratios depicts particular nuances of multiple market dynamics. One of these metrics is the information ratio or IR, which is useful for both investors and market professionals.
What is Information Ratio?
It’s a metric for measuring how a portfolio or financial asset fares in regards to a benchmark, compared to the volatility of its returns.
This benchmark is usually a market index, like Nifty 50. It can also be an index representing any specific industry or market sector. Nevertheless, the Information ratio depicts how well a portfolio or asset is matching and exceeding an index’s returns.
This metric also shows the level of consistency a portfolio is able to achieve in exceeding the returns of such a benchmark. To that end, this ratio also includes the standard deviation component, also called tracking error.
Tracking error shows if a portfolio can regularly “track” and exceed its benchmark’s returns. If such tracking error is low, it means the portfolio is consistent. Conversely, if the error is high, it signifies a more volatile performance.
How is the Information Ratio Calculated?
Calculation of IR takes place based on the following formula –
IR = (Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking Error
Tracking error, on the other hand, is the standard deviation of such investment portfolio’s excess returns with respect to the benchmark.
To determine the annualised Information ratio, one needs to multiply IR by the square root of 252. It’s the count of days in which trading takes place in a year.
The formula for annualised IR is, [(Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking error] x √252
Here’s a step-by-step process of how to calculate Information ratio with unrefined data –
Step 1 – First, note down the daily returns of a portfolio across a specific period, say, a month or quarter or even a year.
Step 2 – Find the average of those returns, which is such a portfolio’s rate of return.
Step 3 – Calculate the index’s rate of return in the same manner.
Step 4 – Next, deduct such benchmark’s returns (Step 3) from the portfolio’s returns (Step 2) to compute the difference.
Step 5 – Calculate the standard deviation of the excess return of such portfolio.
Step 6 – Divide the difference in returns (Step 4) by the tracking error (Step 5) to find out the Information ratio.
An Information Ratio example would better illustrate this process of IR calculation.
A portfolio has posted a rate of return of 12%, while the relevant benchmark shows an 8% rate of return. Its tracking error is 5%.
Therefore, IR = (12% – 8%) / 5%
Or, IR = 0.8
How is Information Ratio Useful?
Information ratio measures the excess returns of an investment portfolio in regards to a benchmark’s gains, and how it’s sustaining overtime.
A high IR would indicate that a portfolio is faring well, meaning it’s posting excess returns consistently. Conversely, a low IR signals a volatile portfolio, signifying excess returns but with less predictability.
Both investors and fund managers make use of IR. Here’s how –
Investors often refer to IR when eying to invest in mutual funds or ETFs. Although a portfolio’s past performance has little bearing on how it will do in the future, Information ratio in mutual funds and ETFs acts as the basis for gauging a fund manager’s competency. Investors use IR to compare fund managers employing similar investment strategies.
An example will better facilitate understanding of the matter.
There are two funds, A and B, with rates of returns of 13% and 10% respectively. Fund manager A’s tracking error comes about to be 8% and that of fund manager B’s is 5%. The benchmark has posted an annualised return of 3%.
Thus, A’s IR = (13% – 3%) / 8%
Or, A’s IR= 1.25
On the other hand, B’s IR = (10% – 3%) / 5%
Or. B’s IR = 1.4
Even though fund manager A has achieved better returns, they have been less consistent compared to fund manager B.
Investors can, therefore, choose fund manager B, owing to the consistency of their performance.
2. Fund manager
The Information ratio acts as a measure of a fund manager’s performance. Fund managers, therefore, use IR or appraisal ratio, to determine their service charges. The better a portfolio manager’s ratio, the higher is their service charge.
What are the Limitations of IR?
The Information ratio measures the risk-adjusted returns of a portfolio, like the Sharpe ratio, apropos a benchmark. And, akin to metrics that determine risk-adjusted returns, its comprehension differs across investors.
Investors with varying risk-aptitudes and investment objectives might have a dissimilar understanding of the same. It depends on factors such as income and age.
Moreover, two portfolios may not share a similar construct, with differing asset allocation, securities, and entry points. Therefore, a comparison between the two might be skewed. Hence, it’s always best to utilise the Information ratio in conjunction with other metrics for a more grounded understanding.
What’s the Difference between the Information and Sharpe Ratio?
The following table demonstrates the difference between these two metrics.
|Parameters||Sharpe Ratio||Information Ratio|
|Definition||It measures the risk-adjusted returns of a fund over its risk-free rate of return.||It measures a portfolio’s risk-adjusted returns apropos a benchmark’s rate of return.|
|Use||It allows the investor to understand the benefits of risk-taking activities.||IR facilitates interpretation of a portfolio’s performance against a benchmark and how it has sustained over time.|
The Information ratio, as well as other metrics, plays a critical role in financial markets. If applied correctly, investors can approach investment decisions in a sounder manner.