Information Ratio

Definition

The Information Ratio (IR) is a financial tool used to evaluate the risk-adjusted return of a financial portfolio or a certain investment strategy. It is calculated as the portfolio’s excess return over a benchmark, divided by the portfolio’s tracking error. The higher the Information Ratio, the more superior a portfolio’s performance is considered to be, relative to its risk-taking.

Phonetic

The phonetic pronunciation of “Information Ratio” is /ˌɪnfərˈmeɪʃən ˈreɪʃioʊ/

Key Takeaways

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1. Measure of Risk-Adjusted Return: The Information Ratio is a tool used to measure the return per unit risk for a given investment portfolio. It is similar to the Sharpe ratio, but it measures the active return of an investor’s portfolio and the negative tracking error. Essentially, it shows how much excess return is being earned for the level of extra risk taken.
2. Comparison Benchmark: Information Ratio compares a portfolio’s return to a benchmark index return, considering the consistency of the portfolio’s performance. It is widely used in portfolio management to assess the performance of a particular investment strategy, as it indicates the consistency of an investment manager’s skill.
3. Interpretation: A high Information Ratio indicates a high risk-adjusted return and is preferable. However, a low Information Ratio may indicate that the risk taken by the investor or investment manager isn’t justified by the returns. Hence, the Information Ratio plays an important role in investment decisions.

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Importance

The Information Ratio (IR) is an important concept in business and finance because it is a crucial tool used for measuring the effectiveness and skill of an investment manager. It gauges the ability of an investment to generate excess returns relative to a benchmark index, while also taking into account the consistency of performance and the volatility of those returns. The IR, therefore, helps investors to understand the risk-adjusted return of an investment, indicating how much risk was taken to achieve a certain level of return. A higher ratio suggests a higher risk-adjusted return, making it very useful for investors when they assess investment options and make investment decisions.

Explanation

The Information Ratio is an essential tool used in the financial industry for assessing the performance of an investment portfolio. Its primary purpose is to measure the potential returns of a portfolio, taking into account the level of risk involved. This ratio allows investors or portfolio managers to quantify and compare the amount of active risk taken to achieve excess returns over a benchmark.The Information Ratio is especially beneficial for market-savvy professionals such as fund managers because it provides a deeper understanding of whether the additional returns, when compared to a benchmark index, are due to strategic investment or just luck. It considers not only the excess returns but also the consistency of the portfolio’s performance. A higher Information Ratio signifies effective investment strategies, while a lower value might indicate poor tactics. So, the Information Ratio plays an integral part in adjusting investment strategies and making financially sound decisions based on precise cost-risk analysis.

Examples

The Information Ratio (IR) is a financial ratio that measures a portfolio manager’s skill and ability to generate excess returns to the risks taken. Here are three real-world examples:1. Vanguard Health Care Fund:Consider a situation where an investor considers investing in the Vanguard Health Care Fund. First, they want to compare this fund to its benchmark index, the MSCI All-Country World Health Care Index. After analysis, it’s found that the fund’s annual return was 10%, while the benchmark index had annual returns of 9%. Moreover, the fund’s tracking error, which measures the standard deviation of the fund’s returns compared to the index, was about 2%. Thus, the Information Ratio would be 0.5 (i.e., (10%-9%)/2%). The positive IR score indicates that the fund manager has managed to outperform the benchmark on a risk-adjusted basis.2. BlackRock Equity Fund:Assume, the BlackRock Equity Fund’s average annual return was 12%, while its benchmark index, the Russell 1000 Index, achieved an annual return of 10%. The fund’s tracking error was 3%. Therefore, the information ratio for the BlackRock Equity Fund would be approximately 0.67 (i.e., (12%-10%)/3%). With a positive IR, it suggests that the fund outperformed its benchmark index after adjusting for the risk undertaken.3. Fidelity Contrafund:Let’s suppose the Fidelity Contrafund had an average return of 13% compared to its benchmark S&P 500’s 11%. If the tracking error is 4%, then the IR would be (13%-11%)/4% equals to 0.5. This positive IR indicates that on a risk-adjusted basis, the Fidelity Contrafund manager has performed better than the benchmark index.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Alpha
• Standard Deviation
• Active Return
• Tracking Error
• Benchmark Portfolio

Sources for More Information

• Investopedia
• Corporate Finance Institute
• CFA Institute
• Wall Street Mojo