Information Ratio: Meaning, Features, Formula, Example

Meaning & Features of Information Ratio

The information ratio determines the fund manager's ability to achieve risk-adjusted results in comparison to the fund's benchmark. A higher information ratio indicates that investment managers have outperformed other fund managers over a defined duration and have achieved stable returns. In comparing a collection of funds with related types of management, the information ratio is helpful. It is determined by dividing a portfolio's excess return over its benchmark by the tracking error. The tracking error is calculated as the standard deviation of the difference between the fund's return and the benchmark return.

The information ratio is based on the scheme's past results and there is no certainty that comparable performance standards can be achieved over a future time horizon. Over the longer term, a reliably high information ratio reflects the capacity of a fund and the fund manager to outperform the selected benchmark. Such consistency encourages investors to invest assets in the fund without the need to time the markets. 

Measuring the associated uncertainties and historical success is very critical for investors in small-cap and mid-cap funds. A strong predictor of past outcomes is the Information Ratio. IR helps to determine whether a fund is reliable and whether or not it has done well with respect to its benchmark.

Generally, an information ratio below 0.4 implies that the mutual fund has not been able to earn excess returns over a sufficiently long period of time and that the fund may not be a suitable investment option. If the information ratio is between 0.4 and 0.6, it is thought to be a good investment and an information ratio between 0.61 and 1 is deemed as a very good option.

How to calculate the Information Ratio?

Information ratio = (R-BR)/w , where

R refers to Portfolio/investment returns

BR refers to Benchmark returns

(R-BR) refers to Active returns of the investment/portfolio

W refers to the Standard deviation of the active returns or tracking error of the scheme

Follow the mentioned steps to calculate Information Ratio

1. Take your mutual fund portfolio and the benchmark results every day or every month for a certain duration.
2. Compare the value between both the benchmark and the returns. To determine the results, check whether the difference is positive or negative.
3. For the whole term, measure the average of the difference.
4. Divide the excess returns by the volatility of the returns above the benchmark. For a given investment, the figure you can get is an information ratio.

Example - Kamlesh wants to invest in a fund, but he is confused between two funds, Fund A and Fund B, say. Now, in order to choose the best alternative, Kamlesh wants to compare the information ratio of these two funds. As the benchmark, let us take the BSE 100 TRI.

Fund A produced 11 percent returns where 8 percent returns were offered by the index and 6 percent is the standard deviation of the tracking error (difference between the fund and index returns). And, Fund B gave 12% returns and the standard deviation is 9%.

Using the Information Ratio formula:

Fund A: IR= (11 percent minus 8 percent)/6 percent = 50%

Fund B: IR= (12% minus 8%)/9 percent = 44%

Fund A's information ratio is higher than Fund B's. This means that Fund A has exhibited a better risk-adjusted return than Fund B.