What does the information ratio (IR) stand for?
If you want to know how much a portfolio’s returns differ from the returns of a standard, which is usually an index, you can use the information ratio (IR). Usually, an index that shows the market or a particular sector or business is used as a benchmark.
The IR is often used to judge how skilled a portfolio manager is and how well they can make higher returns than the norm. It also tries to determine the consistency of performance by adding a tracking error, or standard deviation, to the calculation.
How well the tracking error shows a portfolio “tracks” the success of an index. If the tracking error is low, the portfolio has been beating the average over time. When the tracking error is high, the portfolio results change more over time and don’t always beat the benchmark.
How to Find the Information Ratio (IR) and Its Formula
When you compare funds, their returns may differ, but the IR evens them out by dividing the difference in how well they did, called their projected active return, by their tracking error.
Portfolio Return: Benchmark Return (IR) Tracking MistakeIR stands for “Information Ratio.”Portfolio Return = Return on Portfolio for timeBenchmark return is the amount of money used as a metric. Tracking error is the standard deviation of the gap between portfolio and benchmark returns. Tracking Error (IR)Portfolio Return: Benchmark Return, where IR stands for “Information Ratio. “Portfolio return = return on portfolio for time. Benchmark return is the amount of money used as a metric. Tracking error is the standard deviation of the gap between portfolio and benchmark returns.
To find IR, subtract the total return of the watched benchmark index from the portfolio’s total return for a specific period. Take the answer and divide it by the tracking mistake.
To find the tracking error, take the standard deviation of the difference between the portfolio and index returns. Use a financial tool or Excel to determine the standard deviation to make things easier.
What You Can Learn From the IR
The information ratio shows how much a fund has done better than a standard. When information ratios are high, they show the amount of desired consistency. When information ratios are low, they show the opposite. Many people use the information ratio to choose exchange-traded funds (ETFs) or mutual funds based on the level of risk they are comfortable with. Of course, past success doesn’t always mean what will happen in the future, but the IR is used to see if a portfolio is doing better than a benchmark index fund.
The standard deviation of the return difference between a portfolio and the benchmark index is often used to determine the tracking mistake. The standard deviation is a way to figure out how risky or volatile a purchase is. If the standard deviation is high, there is more change and less stability or dependability. The information ratio helps determine how much and how often a portfolio trades above its benchmark. It also considers the risk that comes with getting those higher yields.
The fees that active fund managers charge are making more people switch to actively managed funds that follow benchmark indexes like the S&P 500. Some investors pay a fund manager between 0.5% and 2% annually to run the fund actively. You should check if the fund consistently performs better than a standard index. The IR calculation can help you get a number that shows how well your fund is being handled.
What the IR and Sharpe Ratio Are Not the Same
Like the information ratio, the Sharpe ratio shows results after considering risk. On the other hand, the Sharpe ratio is found by dividing the difference between an asset’s return and its risk-free rate of return by the asset’s return standard deviation. The rate of return on a risk-free investment, such as a U.S. Treasury bond, would be the same as the risk-free rate of return. If a particular Treasury security paid a 3% yearly yield, that rate would be used as the risk-free rate for comparison in the Sharpe ratio.
The IR looks at the risk-adjusted return compared to a standard, like the Standard & Poor’s 500 Index (S&P 500), rather than a risk-free asset. The IR also checks how consistently a property does well. But the Sharpe ratio shows how much, when risk is considered, a financial portfolio does better than the risk-free rate of return.
Both the risk-free return and the index return are helpful. Still, investors are more interested in the index return because it is higher than the risk-free return, and index funds are often used as a standard to compare investment success.
As with all financial ratios, you shouldn’t use this one to decide if a transaction is a good idea. Using more than one financial measure to evaluate an investment is smarter.
What the Information Ratio (IR) Can’t Do
Any ratio that tracks risk-adjusted returns can mean different things to different investors. Each investor can handle different amounts of risk, and their investment goals may differ based on age, finances, and income. Because of this, each investor sees the IR differently, based on their needs, goals, and level of comfort with risk.
Also, it’s hard to understand the results of comparing several funds to a benchmark because each fund may have different securities, asset allocations for each industry, and entry points for their investments. As with any financial ratio, it’s best to look at several ratios and other financial metrics to make a more well-rounded investment choice.
A Case Study of How to Use the IR
It is possible to have a high IR if the portfolio has a high rate of return compared to the index and the tracked error is low. If the ratio is high, it means that, considering the risk, the manager has regularly made more money than the benchmark index.
Let’s say you want to compare two different fund managers.
It takes 8% longer for Fund Manager A to rebalance than for Fund Manager B.
It takes fund manager B 8.5 years to earn an average return of 8%.
Also, let’s say the index has a 1.5% yearly return.
The IR for Fund Manager A is 1.81, which is 13 minus (-1.5) minus 8. The IR for Fund Manager B is 2.11, which is (8 – (-1.5) / 4.5). Manager B’s portfolio had a better IR than Manager A’s, even though Manager B’s returns were lower. This is because it has a lower standard deviation or tracking error, meaning the portfolio’s performance is more consistent and less risky than the benchmark index.
Just what is a good range for the information ratio?
The ratio of information should be at least 0.5. The higher the information ratio, the better the results will be. Ratios of information of 1 or more would be called good.
Tell me about the difference between tracking errors and information ratios.
An information ratio tells an investor. If the investment or portfolio manager gives them enough profits for the risk they are taking, a tracking error will show how far the investment’s returns are off the standard.
Could an information ratio be bad?
Knowledge ratios can be damaging. The information ratio will be harmful if the return on the investment is less than the standard.
Conclusion
- A measure of how much a portfolio’s returns are above the returns of a standard. Which is usually an index like the S&P 500, called the information ratio (IR).
- The information ratio is used to judge how good a portfolio manager is. making higher returns than a certain standard.
- If the IR score is higher, the portfolio manager is doing a better job and getting a higher return than the standard, considering the risk.
