What is Information Ratio (IR)?

About Information Ratio (IR):

• 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.
• The IR 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 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.
• Calculation of IR takes place based on the following formula:
  • IR = (Portfolio Rate of Returns – Benchmark Rate of Returns)/Tracking Error
• Uses:
  • The IR is primarily used as a performance measure by fund managers.
  • In addition, it is frequently used to compare the skills and abilities of fund managers with similar investment strategies.
  • The ratio provides investors with insights about the ability of a fund manager to sustain the generation of excess, or even abnormal (as in “abnormally high”), returns over time.
  • Finally, some hedge funds and mutual funds use the IR to calculate the fees that they charge their clients (e.g., performance fee).

Q1: What does an information ratio of 0.5 mean?

An IR below 0.5 suggests that the manager may not be effectively utilising their skills to outperform the market, making it a less favourable investment choice. Therefore, investors generally seek strategies or managers with Information Ratios greater than 0.5 for better risk-adjusted returns.

Source: TH