Information Ratio

Definition

The information ratio is a measure used to assess the risk-adjusted return of an investment portfolio, comparing the excess return of the portfolio over a benchmark to the volatility of that excess return. It helps investors understand how much additional return they are getting for each unit of risk taken beyond what the benchmark provides, making it particularly useful in evaluating equity portfolio management strategies and overall investment performance.

5 Must Know Facts For Your Next Test

1. The information ratio is calculated as the excess return (portfolio return minus benchmark return) divided by the tracking error (the standard deviation of excess returns).
2. A higher information ratio indicates that a portfolio manager is delivering better risk-adjusted returns relative to the benchmark, while a ratio below zero suggests underperformance.
3. The information ratio is particularly valuable for active managers who seek to outperform their benchmarks, as it quantifies their effectiveness in generating excess returns.
4. Unlike the Sharpe ratio, which assesses total volatility, the information ratio focuses specifically on active risk relative to a benchmark, making it more relevant for evaluating active management strategies.
5. An information ratio greater than 1 is often considered good, indicating that the portfolio manager has generated significant excess returns for each unit of risk taken.

Review Questions

• How does the information ratio enhance our understanding of an equity portfolio manager's performance compared to a benchmark?
  • The information ratio enhances our understanding by providing a clear metric for evaluating how much excess return a portfolio manager generates relative to a benchmark while accounting for the risk taken. It compares the additional return achieved beyond what would be expected from merely tracking the benchmark against the volatility of those excess returns. A higher information ratio signifies that the manager is not only outperforming but doing so with controlled risk, which is crucial for investors seeking effective management.
• In what ways does the information ratio differ from other performance metrics like alpha and Sharpe ratio when assessing investment performance?
  • The information ratio differs from alpha and Sharpe ratio primarily in its focus on active management. While alpha measures performance relative to a benchmark without considering risk, and the Sharpe ratio evaluates total volatility against overall returns, the information ratio specifically assesses how well an active manager achieves returns above a benchmark in relation to the volatility of those excess returns. This makes it especially relevant for investors looking at actively managed funds and their ability to outperform benchmarks consistently.
• Evaluate how understanding the information ratio can influence investment decisions and portfolio construction strategies for an investor.
  • Understanding the information ratio can significantly influence investment decisions by guiding investors toward portfolios that demonstrate superior risk-adjusted returns. When evaluating potential investments or managers, an investor can use this metric to identify those who consistently generate high excess returns while maintaining acceptable levels of risk. This insight allows investors to construct portfolios that balance potential returns with volatility, ensuring they align with their risk tolerance and investment goals while leveraging managers who excel in generating value relative to their benchmarks.

Related terms

Alpha: Alpha is a measure of an investment's performance relative to a benchmark index, indicating how much better or worse the investment performed compared to the expected return.

Sharpe Ratio: The Sharpe ratio measures the risk-adjusted return of an investment by comparing its excess return to its standard deviation, helping investors understand how well the return compensates for the risk taken.

Tracking Error: Tracking error is the standard deviation of the difference between the returns of a portfolio and its benchmark, serving as an indicator of how closely a portfolio follows its benchmark.