What is Information Ratio in Mutual Funds and How to Use it?

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What is an Information Ratio?

The information ratio compares investments or mutual fund portfolio’s risk-adjusted returns to its benchmark. The goal of this ratio is to indicate excess returns relative to the benchmark, as well as the consistency in generating excess returns. The tracking error measures the consistency with which excess returns are generated.

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The information ratio helps assess an asset manager’s trustworthiness, proficiency in managing risks and outperforming the benchmark. It determines if the fund manager has outperformed the benchmark or not. And also determines the percentage of outperformance.

The Information Ratio measures how successful the fund house’s investment and allocation approach is. You can use it to examine the extra returns generated by the mutual fund against market volatility.

Therefore, choosing a mutual fund for investment is beyond reviewing its historical returns.

Information Ratio = (Portfolio Returns – Benchmark Returns)/ Tracking Error

Tracking Error is a metric that assesses how consistently a portfolio outperforms or outperforms the benchmark. It is the standard deviation of the difference between portfolio returns and benchmark returns.

Importance of Information Ratio in Mutual Funds

A mutual fund portfolio can be managed actively or passively. Passive funds are those funds that replicate the benchmark portfolio. The fund manager has to replicate the benchmark and doesn’t have to manage the fund actively.

On the other hand, active funds have an investment objective and the fund manager continuously strategizes to generate benchmark beating growth. Since active management involves frequent buying and selling, the associated costs are high (expense ratio). Therefore, it is important to ensure the fund manager’s approach is beneficial.

Returns: The ratio helps compare the fund’s returns with its benchmark returns. You can analyze the outperformance or underperformance of the fund compared to its benchmark.
Fund Manager’s Performance: You can evaluate the level of skill of a fund manager by checking how much returns the mutual fund portfolio generated.
Level of Consistency: Using the information ratio, you can understand the mutual fund’s level of consistency in exceeding the benchmark returns.
Tracking Error: With the information ratio, you can determine the tracking error of your investment portfolio. A tracking error shows if the investment portfolio can regularly track the benchmark and outperform it. A low tracking error indicates that the portfolio is consistently outperforming the benchmark. While a high tracking error implies, the fund’s performance is highly volatile.

Learn to Measure Mutual Fund Performance Ratio

How to Calculate Information Ratio?

You can compute the information ratio using the below formula:

Information Ratio = (Portfolio Returns – Benchmark Returns)/ Tracking Error

Following is the step-by-step guide to compute the information ratio:

Step 1: Identify the daily returns of a mutual fund across a specific period – month, quarter or year.
Step 2: Identify the benchmark returns for the same duration.
Step3: Compute the difference between the portfolio and bench market returns. Analyze the difference, positive or negative. This helps you understand the outperformance or underperformance of the fund against its benchmark.
Step 4: Compute the average of the difference.
Step 5: Next, compute the standard deviation of the returns, which gives you the tracking error.
Step6: Divide the average of the difference by tracking error to obtain the information ratio.

A Higher information ratio indicates higher actual returns, and a lower ratio indicates lower actual returns. Therefore, a higher information ratio is always preferable.

Interpretation of Information Ratio

The ratio determines the excess returns of a fund against its benchmark and also how it’s sustaining the outperformance over time.

Over time two funds (Fund A and Fund B) can have the same absolute return. But Fund A has a higher information ratio than Fund B. This indicates that Fund A was more consistent at generating higher returns against its benchmark. While Fund B was outperforming the benchmark by a large margin for some period and underperforming the benchmark during other months.

For Investors

Investors can use this ratio as a metric to shortlist a mutual fund or ETF investment. Though the calculation is based on past returns, the information ratio helps assess the fund manager’s competency in driving the fund to outperform its benchmark. You can use the information ratio to understand the investment and management style of the fund manager. Furthermore, comparing funds belonging to the same category and similar investment strategies will help you decide which fund is better for investment.

Let’s understand the comparison with an example. Suppose Fund A’s return is 20% and Fund B’s is 25%. Both the funds have the same benchmark, whose return is 8%. The tracking error for Fund A is 10%, while the tracking error for Fund B is 13%.

Information Ratio for Fund A = (20 – 8) / 10 = 1.2

Information Ratio for Fund B = (25 – 8) / 15 = 1.1

Though the returns are higher for Fund B, it has a higher tracking error. The information ratio of Fund A is higher than Fund B. Even though Fund B has given better returns, the consistency in its performance is lower in comparison to Fund A. Fund A is more consistent with its returns and hence will be a better investment option over Fund B.

For Fund Managers

This ratio is also called the appraisal ratio. Since you can measure the fund manager’s performance using the ratio. It is used by fund managers themselves to determine their charges. A higher ratio justifies the higher service charge of the fund manager.

Information Ratio vs Sharpe Ratio

Sharpe ratio measures the risk-adjusted returns of an investment over the risk-free rate of return. On the other hand, the information ratio measures the risk-adjusted returns of an investment over its benchmark for a specific duration.

With the Sharpe ratio, you can analyze the risk taken by the fund to generate returns higher than the risk-free rate. On the other hand, using the information ratio, you can understand the fund’s performance against its benchmark and how well it was able to sustain the outperformance over time.

Limitations of Using Information Ratio

Information ratio measures a fund’s risk-adjusted returns and the metric results in wide interpretations. Based on your investment goal, duration, risk tolerance levels, etc., your interpretation might vary from other investors. As a result, investors can have a different opinion on interpreting the ratio.

Furthermore, the investment style, asset allocation, entry and exit levels of the assets for a fund may differ. Therefore, it becomes difficult to interpret the performance of two funds or against the benchmark. Due to this variation, the ratio might not be an accurate metric to compare funds. Hence, you cannot consider the this ratio in isolation while selecting a mutual fund to invest in. You should always consider the information ratio in conjunction with other valuation metrics.

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