Financial Dictionary - Information ratio
The information ratio measures the relationship between the performance spread of a fund or portfolio over its benchmark, and the management risk assumed by separating it to a greater or lesser extent from the benchmark, also known as tracking error.
Information ratio in investment funds and portfolios, which attempts to measure a portfolio manager's level of skill and ability to generate returns or gains over those of the market average, i.e. the return of the index it is compared with. The information ratio (IR) is a measurement of portfolio returns beyond the returns of a benchmark index, taking volatility into account. The information ratio is compared to an index and not to a risk-free asset, so it is more useful for comparing managers' performance.
How is the information ratio calculated?
Information ratio = (PR – BR)/ Te
- PR : portfolio return
- BR: benchmark return
- Te: Tracking Error
What the information ratio is used for
The information ratio is used as a measure of a portfolio manager's level of skill and ability to generate returns or gains over those of the market. Viewed another way, it is an ideal technique for assessing or evaluating whether the manager deserves to earn the fees to be paid for managing the strategy for investing your money.
The higher the information ratio the better, as it means that the manager is good at taking full advantage of the investment, creating a return that is ideal compared to the overall market.
Example of an information ratio
We operate a fund or a portfolio with a return of 11%. (PR)
The benchmark for this portfolio is of an average return of around 9%. (BR)
Tracking error 3%. (Te) = Fund volatility: 7% - index volatility: 4%
If we apply the Information ratio formula = (PR – BR)/ Te
We get the following result: (11-9/3) =0.66
As we can see, 0.66 is a positive result, so the manager is outperforming the market. (If this figure were negative, -0.66, for example, the return would not be adequate. Remember that the higher this figure is, the better the performance will be.
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