Information Ratio is a financial metric that measures the risk-adjusted return of an investment relative to a benchmark. It evaluates how efficiently a portfolio manager generates excess returns compared to the additional risk taken.
Definition
The Information Ratio (IR) is calculated as:
- Information Ratio = (R_p - R_b) / Tracking Error
where:
- R_p – Return of the portfolio.
- R_b – Return of the benchmark.
- Tracking Error – Standard deviation of the excess return (R_p - R_b).
Interpretation
- Higher Information Ratio (> 0.5) – Indicates superior risk-adjusted performance relative to the benchmark.
- Information Ratio between 0 and 0.5 – Suggests moderate outperformance with acceptable risk.
- Negative Information Ratio – The portfolio underperforms the benchmark, meaning the excess risk is not justified.
Example Calculation
Suppose:
- Portfolio return (R_p) = 12%
- Benchmark return (R_b) = 8%
- Tracking error = 4%
The Information Ratio is:
- (12% - 8%) / 4% = 1.0
Advantages
- Benchmark-relative performance – Helps compare how well a portfolio performs against a benchmark.
- Risk-adjusted return analysis – Accounts for excess risk taken.
- Useful for active managers – Evaluates the effectiveness of investment strategies.
Limitations
- Dependent on benchmark choice – Different benchmarks may yield different IR values.
- Does not account for downside risk separately – Unlike the Sortino Ratio.
- Sensitive to tracking error fluctuations – A low tracking error can inflate IR artificially.
Applications
- Performance evaluation of actively managed funds.
- Assessing portfolio managers' consistency in generating alpha.
- Comparing investment strategies to determine risk-adjusted effectiveness.
Variations
- Sharpe Ratio – Measures absolute risk-adjusted return, unlike IR which is benchmark-relative.
- Sortino Ratio – Focuses only on downside risk, whereas IR considers total risk.