Information Ratio

Definition

The information ratio is a measure used to evaluate the risk-adjusted performance of an investment portfolio, specifically focusing on the excess return generated relative to the volatility of those returns. It helps investors understand how much additional return they are receiving for each unit of risk taken, making it a key metric in performance measurement and reporting.

5 Must Know Facts For Your Next Test

1. The information ratio is calculated by dividing the excess return of a portfolio over a benchmark by the tracking error.
2. A higher information ratio indicates better risk-adjusted performance, meaning an investor is earning more return for each unit of risk taken.
3. An information ratio greater than 1 is generally considered good, while a ratio less than 0 indicates underperformance compared to the benchmark.
4. It is often used by active fund managers to demonstrate their ability to generate alpha through effective security selection.
5. While useful, the information ratio should be considered alongside other metrics to get a complete picture of performance.

Review Questions

• How does the information ratio help investors assess the performance of an investment portfolio?
  • The information ratio aids investors by quantifying how much excess return a portfolio generates compared to a benchmark, relative to the risk involved in achieving that return. By calculating the ratio, investors can evaluate whether the additional returns justify the risks taken, which is essential for informed investment decisions. A higher ratio indicates better performance and efficiency in generating returns.
• Compare and contrast the information ratio with the Sharpe ratio in terms of their use in performance measurement.
  • The information ratio and Sharpe ratio are both important metrics for assessing investment performance but focus on different aspects. While the information ratio measures excess returns relative to a benchmark and accounts for tracking error, the Sharpe ratio compares excess returns to total risk measured by standard deviation. Thus, the information ratio is particularly useful for evaluating active managers against their benchmarks, whereas the Sharpe ratio applies to any investment strategy regardless of benchmark.
• Evaluate the limitations of using the information ratio as a sole measure for assessing investment performance.
  • While the information ratio provides valuable insights into risk-adjusted returns, relying solely on it can be misleading. It does not account for factors such as market conditions or changing volatility over time, which can impact both excess returns and tracking error. Furthermore, an elevated information ratio might not reveal underlying issues if a portfolio takes on extreme risks to achieve those returns. Therefore, it is important to use it alongside other metrics like alpha and beta for a more comprehensive evaluation.

Related terms

Sharpe Ratio: A ratio that measures the risk-adjusted return of an investment by comparing its excess return to its standard deviation.

Alpha: A measure of an investment's performance on a risk-adjusted basis, representing the excess return over a benchmark index.

Tracking Error: The standard deviation of the difference between the returns of a portfolio and its benchmark, indicating how closely a portfolio follows its benchmark.