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Information Ratio

A measure of the risk-adjusted returns of a financial asset or portfolio relative to a certain benchmark

What is the Information Ratio?

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.

 

Information Ratio

 

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 in a way. 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:

 

Information Ratio - Formula

 

Where:

  • Ri– the return of a security or portfolio
  • R– 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)

 

Example of the Information Ratio

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:

 

Sample Data

 

Using the information above, we can calculate the information ratios for the funds:

 

Sample Calculation

 

The ABC Fund shows a higher information ratio than the XYZ Fund. It indicates that the ABC Fund can more consistently generate excess returns, as compared to the XYZ Fund.

 

More Resources

Thank you for reading CFI’s explanation of the Information Ratio. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Investing: A Beginner’s Guide
  • Equity Risk Premium
  • Rate of Return
  • Risk Management

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