Information Ratio

The information ratio is a versatile and useful risk-adjusted measure of actively managed fund performance. It assesses the degree to which a manager uses skill and knowledge to enhance the fund returns.

It is calculated by deducting the returns of the fund’s benchmark by the fund’s overall returns. This result is then divided by the fund’s tracking error, which is a measure of the volatility of the fund’s excess returns. The value that is arrived is an expression of, for each unit of extra risk assumed, the success of the manager’s decisions (“tilts”) away from the benchmark.

The higher the information ratio, the better. It is generally considered that a figure of 0.5 reflects a good performance, 0.75 very good, and 1 outstanding. This is particularly useful when comparing a group of funds with similar management styles and asset allocation policies. If two funds have near-identical alphas, the higher information ratio identifies the manager who has been more skilful in betting on stock picks that deviated from the benchmark or index, while the lower denotes gains that have more to do with market movements than active management. However, this comes with both a caveat and a means of using it creatively. As ever, the r-squared correlation between the fund and its benchmark must be strong if any discrete reliance is to be placed on the information ratio. Its versatility, however, comes from the point that “added value” does not necessarily mean value added to the fund’s own benchmark. Analysts can decide which benchmark or index they wish the fund to outperform and adjust the statistics accordingly.