What is the Information Ratio?
Sean P. Gilligan, CFA, CPA, CIPM
December 3, 2020
The Information Ratio is an appraisal measure used to evaluate the skill of a portfolio manager. This ratio is calculated by dividing a strategy’s excess return by its tracking error, which allows us to assess the performance of a strategy relative to its benchmark, after adjusting for risk. Rather than using standard deviation (total risk) or beta (systematic risk) to account for risk, the Information Ratio uses tracking error, which is the standard deviation of the differences in return between the strategy and the benchmark. By scaling excess return by risk, we can compare the performance of multiple managers under consideration in a more equitable manner.
When using Information Ratio, it is important that the benchmark matches the manager’s specific style (i.e., they have the same risk profile). If the benchmark used to evaluate Information Ratio is not truly representative of the risk taken by the manager, the results will be less meaningful. That is, if excess return is earned by deviating from the risk profile of the benchmark, the tracking error will be higher, thus lowering the Information Ratio. This form of risk scaling allows us to identify managers that achieve excess returns without materially deviating from the risk profile of the benchmark.
Information Ratio Formula
Annualized Information Ratio
If using annual or annualized input data, then the results are already in annual terms. When calculating the Information Ratio using monthly data, the Information Ratio is annualized by multiplying the entire result by the square root of 12.
What is a Good Information Ratio?
A positive Information Ratio indicates excess return over the benchmark and a negative Information Ratio signifies underperformance. Since tracking error represents the strategy’s consistency with the benchmark, the Information Ratio reveals the level of consistency in which the strategy has achieved its excess returns.
Similar to the Sharpe Ratio, the Information Ratio is usually used as a ranking device to compare managers rather than to evaluate a manager independently; however, some do believe that the Information Ratio can provide insight into the skill of a manager on its own. Generally, an information ratio of 0.5 is considered good while a ratio of 0.75 is very good and 1.0 or higher is exceptional. Just like other appraisal measures, the results are more meaningful when assessed over longer periods, ideally 36 months or more, as it is much easier to achieve positive results in the short term.
Information Ratio Calculation Example
Suppose two similar strategies, Strategy A and Strategy B, had the following annualized characteristics.
Although the strategies have the same annualized excess return, the Information Ratios differ due to their differences in tracking error. Because Strategy A has a higher Information Ratio, it would be preferred over Strategy B to an investor deciding between the two.
Again, this calculation implicitly assumes that the benchmarks used correspond to the respective risk profile of each strategy.
Information Ratio Interpretation
Often, annualized Information Ratios are used to rank managers. This direct comparison works well when comparing managers with the same length of performance history; however, it is important to also consider if any adjustments are needed to compare managers with different lengths of performance history. For example, a manager’s annualized Information Ratio calculated using 10 years of history compared to a different manager’s Information Ratio calculated using 3 years of history may not be perfectly comparable for two reasons: 1) the excess returns may have at least partially been earned under different market conditions and 2) a shorter track record provides us with less statistical confidence in the results.
Regarding statistical significance, it is important to remember that all performance appraisal measures are estimated with error. Using t-statistics to measure statistical significance of the results (i.e., adjusting to assign more confidence to a longer track record) may add value to simply comparing pure Information Ratios. That is, without considering statistical confidence levels, we may select a manager with a higher Information Ratio despite their being less certainty in the meaningfulness of their results compared to a manager with a longer track record and slightly lower Information Ratio.
Additionally, it is important to consider multiple appraisal measures when evaluating a manager to ensure you have the full picture of the manager’s skill. If you want to compare Information Ratio to other ratios like Sharpe Ratio or Sortino Ratio, take a look at What is the Sharpe Ratio or What is the Sortino Ratio?
Why is the Information Ratio Important?
When managers are compared that have similar styles and active risk budgets, the Information Ratio is a valuable tool to identify skill and rank managers. Managers in a peer group may indicate that they have a similar risk profile and track the same benchmark. Using tracking error to risk-adjust the excess return of each manager can test whether the managers truly have similar risk profiles. The Information Ratio helps us identify which managers consistently earned their excess return without material deviations from the risk profile of the benchmark or other managers in their peer group.
Information Ratio Calculation: Using Arithmetic Mean or Geometric Mean
Because the Information Ratio compares return to risk (through tracking error), Arithmetic Mean should be used to calculate the strategy return. Geometric Mean penalizes the return stream for taking on more risk. However, since the Information Ratio already accounts for risk in the denominator, using Geometric Mean in the numerator would account for risk twice. For more information on the use of arithmetic vs. geometric mean when calculating performance appraisal measures, please check out Arithmetic vs Geometric Mean: Which to use in Performance Appraisal.
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