Information Ratio: Meaning, Formula & How to Calculate

Learn what the Information Ratio is, how it is calculated using excess returns and tracking error, and how it is used to assess portfolio performance consistency.

The information ratio (IR) is a financial metric used to assess the performance of an investment relative to a benchmark, while considering the volatility of the excess returns. A higher information ratio indicates that the investment manager is delivering risk-adjusted returns relative to the benchmark.

The information ratio measures the consistency of a portfolio's performance in relation to its benchmark. It helps investors understand how much excess return is being generated per unit of risk (tracking error) taken relative to the benchmark. A higher IR suggests higher relative performance, while a lower IR indicates weaker performance.

The information ratio measures two main aspects:

• Excess return: The difference between the portfolio's return and the benchmark return.

• Tracking error: The standard deviation of the excess return (how volatile the excess return is).

The ratio helps evaluate how efficiently a portfolio is outperforming its benchmark, taking into account the risk associated with that outperformance.

The information ratio is important because it helps evaluate how effectively a portfolio performs relative to its benchmark:

• Shows consistency: A higher information ratio indicates that excess returns are generated more consistently over time, rather than through occasional outperformance.
  

• Risk-adjusted performance: It assesses whether the additional returns earned above the benchmark adequately compensate for the extra risk taken, measured through tracking error.
  

• Manager evaluation: A higher information ratio suggests that the fund manager’s active decisions are adding value in a controlled and repeatable manner, rather than relying on market movements alone.

The information ratio can be calculated using the following formula:

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

Where:

• Portfolio Return is the return generated by the investment portfolio.

• Benchmark Return is the return of the chosen benchmark index.

• Tracking Error is the standard deviation of the difference between the portfolio return and the benchmark return.

Information Ratio Formula

The formula for the information ratio is simple:

IR = Excess Return / Tracking Error

Where:

• Excess Return is the difference between the portfolio return and the benchmark return.

• Tracking Error is the standard deviation of the differences between the portfolio return and the benchmark return.
   

Understanding Components of Information Ratio

The key elements used to assess how a portfolio performs are as follows:

1. Excess return: This represents the additional return earned by a portfolio over its benchmark. It shows how much value the portfolio generates beyond simply matching the benchmark’s performance.

2. Tracking error: This measures the variability of the portfolio’s excess returns compared to the benchmark. A higher tracking error indicates larger deviations from the benchmark, reflecting more active investment decisions.

Let’s calculate the information ratio using an example:

• Portfolio return: 12%

• Benchmark return: 8%

• Standard deviation of excess return (tracking error): 4%

Using the formula:

IR = (12% - 8%) / 4% = 1.0

In this case, the information ratio of 1.0 indicates that the portfolio has generated an excess return of 1% for every 1% of risk taken relative to the benchmark.

While the information ratio is useful, it has some limitations:

• Benchmark dependency: The choice of benchmark significantly impacts the ratio. A poor benchmark selection can skew results.

• Tracking error: A low tracking error does not necessarily indicate stronger relative performance; it may simply reflect that the portfolio is closely replicating the benchmark.

• Short-term focus: The information ratio may vary significantly over shorter periods, potentially misleading investors.

The information ratio is widely used in:

• Fund management: Active fund managers use the information ratio to assess their performance relative to a benchmark.

• Investors: To evaluate the consistency of a portfolio’s outperformance.

• Institutional investors: To decide which managers are delivering higher risk-adjusted returns relative to peers.

The information ratio helps evaluate how consistently a portfolio outperforms its benchmark after accounting for risk. By focusing on excess return and tracking error, it offers a clear view of whether outperformance is driven by skill rather than chance or higher risk.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.