Information Ratio

Definition

The information ratio is a measure used to evaluate the performance of an investment by comparing its excess returns to its tracking error, essentially assessing how much additional return an investor earns for each unit of risk taken. It connects to portfolio diversification by helping investors understand the effectiveness of alternative investments in achieving superior returns relative to their risks. A higher information ratio indicates better performance relative to a benchmark, making it a vital tool for analyzing historical performance and risk-return profiles of various asset classes, including alternatives.

5 Must Know Facts For Your Next Test

1. An information ratio greater than 1 is generally considered good, indicating that an investment has produced higher returns than what would be expected based on its level of risk.
2. This ratio helps investors compare different investments or managers by providing a standardized measure of performance relative to risk.
3. Investors often use the information ratio to assess active fund managers' skill in generating excess returns while minimizing risk, particularly in alternative investments.
4. The calculation for the information ratio is done using the formula: $$IR = \frac{(R_p - R_b)}{\sigma_e}$$ where $$R_p$$ is the portfolio return, $$R_b$$ is the benchmark return, and $$\sigma_e$$ is the tracking error.
5. In periods of high market volatility, a consistently high information ratio can indicate a manager's ability to navigate risks effectively while delivering excess returns.

Review Questions

• How does the information ratio help investors assess alternative investments in terms of their contribution to overall portfolio diversification?
  • The information ratio provides investors with a clear view of how much excess return an alternative investment generates relative to its risk. By analyzing this ratio across different assets, investors can identify which alternatives contribute positively to overall portfolio diversification. A higher information ratio suggests that an alternative investment not only has a good track record but also aligns well with the goal of maximizing returns while managing risk, thereby enhancing overall portfolio performance.
• Discuss the relationship between tracking error and information ratio in evaluating an investment's performance against a benchmark.
  • Tracking error plays a crucial role in calculating the information ratio as it measures how much an investment's returns deviate from its benchmark. A lower tracking error signifies that an investment closely follows its benchmark, whereas a higher tracking error indicates more significant deviations. In the context of the information ratio, if an investment generates higher excess returns with a low tracking error, it will result in a higher information ratio, reflecting superior performance relative to its benchmark while taking on acceptable levels of risk.
• Evaluate how understanding the information ratio can influence an investor's decision-making process regarding active fund managers in alternative investments.
  • Understanding the information ratio equips investors with insights into which active fund managers consistently generate excess returns over their benchmarks while managing risk effectively. When analyzing different managers, a higher information ratio signals skillful management that adds value beyond mere market exposure. This knowledge influences decision-making by guiding investors toward selecting managers who are likely to continue outperforming through various market conditions, ultimately leading to more informed choices about incorporating alternative investments into their portfolios.

Related terms

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

Sharpe Ratio: A measure that indicates the average return minus the risk-free rate divided by the standard deviation of return, used to evaluate the risk-adjusted return of an investment.

Alpha: The excess return of an investment relative to the return of a benchmark index, representing the value added by active management.