Understanding Information Ratio: A Guide to Measuring Risk-Adjusted Returns
Introduction
In today’s financial world, measuring investment returns is not just a matter of looking at the numbers that represent profits and losses. It’s also essential to consider the level of risk involved in any investment, as this can have a significant impact on the overall performance of the portfolio. This is where the concept of information ratio comes in, which helps investors evaluate the effectiveness of a portfolio manager in delivering returns that compensate for the level of risk taken. In this article, we will take a closer look at this important metric and explore how it can help you make better investment decisions.
What is Information Ratio?
Information ratio is a risk-adjusted performance measure that assesses the amount of excess returns an investment has generated relative to the level of risk taken to achieve those returns. It is calculated by dividing the excess returns of the investment by its tracking error, which represents the level of risk or deviation from the benchmark index. The higher the information ratio, the better the performance of the investment relative to its risk.
How to Calculate Information Ratio
To calculate information ratio, you need to first determine the excess returns of the investment by subtracting the benchmark returns from the investment returns. Next, you need to calculate the tracking error, which can be done by subtracting the benchmark returns from the actual returns for each period, squaring the differences, adding them up, and taking the square root. Finally, divide the excess returns by the tracking error to get the information ratio.
Why is Information Ratio Important?
Information ratio is an important tool for investors because it helps to assess the performance of the fund manager based on risk-adjusted returns. By considering both returns and risk, investors can better understand how much value the manager is adding to their portfolio compared to the benchmark. This is important because it is not enough to simply outperform the benchmark; the level of risk taken to achieve that outperformance also needs to be considered. A high information ratio suggests that the manager is skilled at generating returns that compensate for the level of risk taken, while a low ratio may indicate that the manager is not adding enough value or taking on too much risk.
Examples of Using Information Ratio
Let’s say that you are considering investing in two mutual funds that both have annual returns of 12%. Fund A has a tracking error of 5%, while Fund B has a tracking error of 10%. If you are risk-averse, you may be more inclined to invest in Fund A because it has a higher information ratio of 1.4 compared to Fund B’s 1.2, indicating that it has higher risk-adjusted returns.
Another example could be a situation where two fund managers are being evaluated for a particular mandate, and their returns are identical. However, one manager has a higher information ratio than the other, indicating that they are generating those returns with lower risk. In such circumstances, the manager with the higher information ratio would be the better choice.
Conclusion
Information ratio is a valuable metric for investors seeking to evaluate the risk-adjusted returns of their investments. By considering the excess returns generated by the investment and dividing it by the tracking error, investors can gain a deeper understanding of the skill of the fund manager in managing risk and delivering returns that compensate for that risk. When evaluating investment opportunities, keep in mind that a high information ratio may indicate a skilled manager who can add value while effectively managing risk.
