Information Ratio

Definition

The information ratio is a risk-adjusted measure of active portfolio management that quantifies the active return of a portfolio relative to the active risk taken. It is used to evaluate the skill of an investment manager in generating excess returns over a benchmark index, while accounting for the risk taken to achieve those excess returns.

5 Must Know Facts For Your Next Test

1. The information ratio is calculated as the active return divided by the active risk, or tracking error.
2. A higher information ratio indicates a more efficient use of risk by the investment manager, as they have generated more excess return per unit of active risk taken.
3. The information ratio is useful for comparing the risk-adjusted performance of different investment managers or strategies, as it provides a standardized metric for evaluating skill.
4. Investment managers often seek to maximize the information ratio as a key objective, as it aligns with the goal of generating the highest possible excess returns for a given level of active risk.
5. The information ratio is a valuable tool for performance measurement and can help investors assess the effectiveness of an active management approach in a portfolio context.

Review Questions

• Explain how the information ratio is calculated and what it measures.
  • The information ratio is calculated as the active return (the difference between the portfolio's return and the benchmark's return) divided by the active risk, or tracking error (the standard deviation of the active return). This metric measures the skill of an investment manager in generating excess returns relative to the risk taken to achieve those excess returns. A higher information ratio indicates a more efficient use of risk, as the manager has generated more excess return per unit of active risk.
• Describe the role of the information ratio in evaluating the performance of an active investment strategy.
  • The information ratio is a valuable tool for assessing the risk-adjusted performance of an active investment strategy. It allows investors to compare the skill of different investment managers or strategies by providing a standardized metric that accounts for both the excess returns generated and the level of active risk taken. A higher information ratio suggests that the investment manager has been more effective in generating excess returns for a given amount of active risk, making it a useful metric for evaluating the overall effectiveness of an active management approach within a portfolio context.
• Analyze how the information ratio can be used to align the objectives of an investment manager with the goals of an investor.
  • Investment managers often seek to maximize the information ratio as a key objective, as it aligns with the goal of generating the highest possible excess returns for a given level of active risk. This incentivizes the manager to focus on generating consistent, risk-adjusted outperformance rather than simply taking on excessive risk in pursuit of higher returns. From an investor's perspective, the information ratio provides a valuable metric for assessing the skill and efficiency of the investment manager, allowing them to make more informed decisions about the active management approach within their portfolio and whether it is likely to meet their investment objectives.

Related terms

Active Return: The difference between the portfolio's return and the benchmark's return, representing the value added by the investment manager's active decisions.

Active Risk: The standard deviation of the active return, measuring the volatility or riskiness of the portfolio's active bets relative to the benchmark.

Tracking Error:

The standard deviation of the difference between the portfolio's returns and the benchmark's returns, quantifying the divergence of the portfolio from the benchmark.