Information Ratio

Definition

The information ratio is a measure used to evaluate the performance of an investment portfolio by comparing its excess return to its tracking error. It essentially helps investors understand how much additional return they are receiving for each unit of risk taken, specifically in the context of a benchmark. A higher information ratio indicates a more favorable risk-return profile, making it a crucial tool for assessing the effectiveness of international portfolios in generating returns above a benchmark while managing risk.

5 Must Know Facts For Your Next Test

1. The information ratio is calculated using the formula: $$IR = \frac{(Portfolio Return - Benchmark Return)}{Tracking Error}$$.
2. An information ratio greater than 1 is generally considered good, indicating that the portfolio is delivering excess returns relative to the risk taken.
3. It is especially useful in comparing the performance of different managers or funds that have similar investment objectives and benchmarks.
4. The information ratio can help identify consistent outperformers in international portfolios, as it focuses on long-term risk-adjusted returns rather than short-term volatility.
5. This ratio does not account for absolute returns, so a positive information ratio can still occur even if both the portfolio and benchmark have negative returns.

Review Questions

• How does the information ratio assist investors in evaluating portfolio performance in relation to a benchmark?
  • The information ratio helps investors assess how well a portfolio is performing compared to a benchmark by measuring the excess return achieved per unit of tracking error. This allows investors to determine whether portfolio managers are generating sufficient returns given the risks involved. A higher information ratio suggests that the manager is effective at delivering excess returns, making it easier for investors to make informed decisions about their portfolios.
• In what ways can the information ratio provide insights into the consistency of an investment manager's performance over time?
  • The information ratio focuses on the relationship between excess return and tracking error, which allows for an evaluation of consistency in an investment manager's performance. If a manager consistently achieves a high information ratio, it indicates that they are regularly generating returns above their benchmark while effectively managing risk. This consistency is vital for investors who seek reliable long-term performance, especially in international portfolios where market dynamics can be unpredictable.
• Evaluate how incorporating the information ratio into performance assessment can enhance decision-making for investors managing international portfolios.
  • Incorporating the information ratio into performance assessment enhances decision-making by providing a clear view of how much value an investment manager adds relative to the risk taken. By focusing on both excess return and tracking error, investors can distinguish between managers who simply take on more risk and those who effectively manage that risk to achieve better returns. This nuanced understanding allows investors to allocate resources more strategically across different international portfolios, optimizing their overall investment strategy based on proven performance metrics.

Related terms

Excess Return: The return of an investment portfolio above the return of a benchmark or risk-free rate.

Tracking Error: The standard deviation of the difference between the return of a portfolio and the return of its benchmark.

Sharpe Ratio:

A measure that evaluates the performance of an investment by adjusting for its risk, calculated as the ratio of excess return to total risk.