The information ratio measures the risk-adjusted returns of a financial asset or portfolio relative to a certain benchmark. This ratio aims to show excess returns relative to the benchmark, as well as the consistency in generating the excess returns. The consistency of generating excess returns is measured by the tracking error.
The selection of the benchmark is subjective. The most commonly used benchmarks are the yields of government-issued bonds (e.g., US Treasury Bills) or a major equity index (e.g., S&P 500).
Uses of the Information Ratio
The information ratio 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 information ratio to calculate the fees that they charge their clients (e.g., performance fee).
The information ratio and the Sharpe ratio are similar. Both ratios determine the risk-adjusted returns of a security or portfolio. However, the information ratio measures the risk-adjusted returns relative to a certain benchmark while the Sharpe ratio compares the risk-adjusted returns to the risk-free rate.
Formula for Calculating the Information Ratio
The information ratio is calculated using the formula below:
Ri– the return of a security or portfolio
Rb – the return of a benchmark
E( Ri – Rb)– the expected excess return of a security or portfolio over benchmark
δib– the standard deviation of a security or portfolio returns from the returns of a benchmark (tracking error)
John is willing to invest his money in a hedge fund. He considers the ABC Fund and XYZ Fund. In order to choose the right fund, John wants to compare the information ratios for the two funds. The benchmark for the ratio’s calculation is the S&P 500 index. The information about the funds is summarized in the table below:
Using the information above, we can calculate the ratios for the funds:
The ABC Fund shows a higher ratio than the XYZ Fund. This indicates that the ABC Fund can more consistently generate excess returns, as compared to the XYZ Fund.
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