What is Information Ratio?

The common perception is that mutual funds are one of the easier avenues to invest in, considering an expert fund manager takes care of one’s investment portfolio. However, you should perform your checks as well. This is important, considering you will be able to make an informed decision.While comparing your investment vis-à-vis the benchmark index is a great tool to understand fund performance; as a serious investor, you should not rely only on it. This is where Information Ratio (IR) becomes essential.

Information Ratio helps you to gauge the fund manager’s consistency and expertise in minimising risks, going beyond the benchmark, and delivering risk-adjusted returns. A higher ratio indicates that the fund manager has been able to outdo his counterparts in generating superior returns consistently, over a period of time.

This is helpful when it comes to comparing funds (or portfolios) that have similar styles of management. You can calculate this ratio by dividing a portfolio’s active returns by its tracking error. Tracking error refers to the standard deviation of the difference between index returns and fund returns.The formula for calculating Information Ratio is: IR = R-BR/w Where, R refers to portfolio returns BR refers to benchmark returns
w refers to the scheme’s tracking error (standard deviation of active returns)

• This ratio helps to determine the margin by which your investment portfolio is trading in excess of the benchmark. Simply said, Information Ratio provides a quantitative analysis of your fund manager’s ability to deliver portfolio returns that exceed returns generated by the benchmark.However, should the benchmark change, the ratio of the scheme will as well.
• The ratio bases itself on historical returns; there is no guarantee that similar performance will be repeated every time.

• The Information Ratio is a more accurate tool as compared to Sharpe Ratio considering it doesn’t merely equate returns with the benchmark, but also accounts for market volatility.
• The Sharpe Ratio calculates investor returns against market volatility, whereas Information Ratio reveals the margin by which portfolio returns (delivered by your fund manager) have outperformed benchmark returns.
• Higher the Information Ratio, the better. The key here is consistency, considering entry and exit times for investors will always vary. However, this should not affect fund performance.

You must understand the concept of ‘Alpha’ before you decide to use Information Ratio to analyse fund performance. Alpha measures how a fund performs and its is calculated after adjusting the risk. Therefore, alpha is the excess returns generated by a fund relative to the returns of the benchmark index. In conclusion By using the Information Ratio accurately, you will be able to choose the best mutual funds and fund managers for your portfolio.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.