What is the Information Ratio (IR) in Mutual Fund?

Investors rely on the vital practice of ratio analysis. These ratios are the cornerstone of decision-making processes for many investors, governing a wide spectrum of investment instruments. 

Each of these ratios acts as a lens, offering nuanced insights into the financial markets. One such metric which assesses a portfolio’s risk-adjusted returns is the Information Ratio, also known as the Appraisal Ratio. 

In this article, we will understand the meaning and importance of the Information Ratio. We will also delve into the workings of the Information Ratio and how you can use it as an investor.

What is the Information Ratio?

Information ratio is a measure to assess how a portfolio or financial asset performs with respect to a chosen benchmark while taking into account the volatility of its returns.

Typically, this benchmark is represented by a market index, such as the Nifty 50, although it can also pertain to an index specific to a particular industry or market sector. The Information ratio gauges the extent to which a portfolio or asset aligns with and outperforms the returns of an index.

This metric provides insights into the level of consistency that a portfolio can maintain in surpassing the returns of said benchmark. The ratio incorporates an element known as the standard deviation, often referred to as tracking error.

Here, tracking error reveals whether a portfolio can consistently mirror and exceed the returns of its benchmark. When the tracking error is low, it signifies that the portfolio exhibits a steady performance. Conversely, a high tracking error indicates a more volatile performance.

Formula to Calculate Information Ratio

Information Ratio (IR) = (Portfolio Return – Benchmark Return) / Tracking Error

Here’s what each component of the formula represents:

1. Portfolio Return: This is the return earned by the investment portfolio over a specific period, typically measured in percentage terms.
2. Benchmark Return: It represents the expected or average return of a similar investment, often an index that closely mirrors the portfolio’s investment strategy. In the Indian context, we can consider the Nifty 50 as a common benchmark.
3. Tracking Error: It measures the standard deviation of the portfolio’s excess returns compared to the benchmark. It provides insight into how consistently the portfolio outperforms or underperforms the benchmark.

Example of Information Ratio

Let’s say you’re evaluating the performance of a mutual fund that primarily invests in the equity market. The fund’s benchmark is the Nifty 50, which represents the performance of the top 50 stocks on the National Stock Exchange (NSE).

Portfolio Return: Over the last year, the mutual fund generated a return of 15%.

Benchmark Return: During the same period, the Nifty 50 index delivered a return of 12%.

Tracking Error: The tracking error, which measures the volatility of the mutual fund’s returns relative to the Nifty 50, is calculated to be 8%.

Now, let’s calculate the Information Ratio:

Information Ratio (IR) = (15% – 12%) / 8% = 0.375

In this example, the Information Ratio (IR) is 0.375. 

This means that for every unit of tracking error (volatility), the mutual fund’s portfolio manager has generated an excess return of 0.375 units compared to the benchmark.

Interpreting Information Ratio

• An Information Ratio greater than 0 indicates that the portfolio has outperformed the benchmark on a risk-adjusted basis. In our example, the mutual fund has generated excess returns compared to the Nifty 50, considering the level of risk (volatility) involved.
• A higher Information Ratio suggests that the portfolio manager has added value through skilful investment decisions. Conversely, a lower or negative Information Ratio may indicate that the portfolio has underperformed the benchmark relative to the risk taken.

How is the Information Ratio Useful?

1. Evaluating Portfolio Managers: Investors often rely on portfolio managers to handle their investments. Information Ratio helps assess the manager’s skill in generating returns above the market or a chosen benchmark. By comparing the Information Ratio of different portfolio managers, investors can identify those who consistently outperform the market with a well-balanced level of risk. 
2. Risk-Adjusted Returns: One of the key nuances of the Information Ratio is its focus on risk-adjusted returns. It doesn’t merely consider how much a portfolio has gained; it also accounts for the risk taken to achieve those gains. As an investor, it is essential because higher returns are not always better. Investors need to consider the risk involved. The Information Ratio helps in identifying portfolios that provide better risk-adjusted returns.
3. Customised Investment Strategies: Different investors have varying risk tolerances and investment objectives. Some might prioritise capital preservation, while others seek aggressive growth. The Information Ratio allows investors to customise their investment strategies based on their risk preferences. For example, an investor looking for steady returns with minimal risk might choose a portfolio manager or strategy with a lower Information Ratio but lower associated risk.
4. Benchmark Comparison: Investors often use benchmarks to gauge the performance of their investments. The Information Ratio provides a nuanced way to compare a portfolio’s performance against a benchmark. This comparison helps investors understand whether the portfolio manager is adding value by outperforming the benchmark or if they might be better off with a passive investment strategy that closely tracks the benchmark.
5. Long-Term Perspective: A long-term perspective is crucial for an investor. The Information Ratio can reveal a portfolio manager’s consistency in delivering returns over an extended period. Investors can use the Information Ratio to differentiate between short-term luck and sustained skill. 

What are the Limitations of IR?

The Information Ratio, while a valuable metric for assessing a portfolio manager’s performance, does have its limitations. It’s important to be aware of these limitations when using this metric.

• Dependency on Benchmark Choice: The Information Ratio heavily relies on the chosen benchmark. A change in the benchmark can lead to significantly different ratios, making comparisons tricky. Careful consideration of the benchmark’s appropriateness is crucial.
• Short-Term Focus: This ratio tends to be more effective for short-term investments due to its sensitivity to short-term fluctuations. For long-term investors, it might not provide an accurate assessment of performance.
• Volatility Sensitivity: The Information Ratio is sensitive to portfolio volatility. A higher volatility can sometimes result in a better ratio, which may not necessarily indicate superior management skills.
• No Risk-Free Rate Consideration: Unlike the Sharpe Ratio, the Information Ratio doesn’t consider the risk-free rate, which could lead to misinterpretation when assessing risk-adjusted returns.
• Lack of Diversification Assessment: This metric doesn’t assess diversification. A manager might achieve a high Information Ratio through undiversified, risky bets that aren’t suitable for all investors.

What is a Good Information Ratio?

A good Information Ratio (IR) is typically above 0.5, signifying that an investment or portfolio manager is generating returns that surpass the market benchmark after considering the risks taken. 

The higher the IR, the better, as it indicates the manager’s ability to consistently deliver value beyond what can be attributed to market movements. An IR below 0.5 suggests that the manager may not be effectively utilising their skills to outperform the market, making it a less favourable investment choice. 

Therefore, investors generally seek strategies or managers with Information Ratios greater than 0.5 for better risk-adjusted returns.

Information Ratio vs Sharpe Ratio

FAQs

This article has been written for educational purposes only. The securities quoted are only examples and not recommendations.