Looking for benchmark-beating funds? This ratio tells you who’s truly skilled!

In the world of investing, especially when evaluating actively managed mutual funds, returns alone don’t tell the full story. A fund may beat its benchmark, but was that outperformance consistent or just a stroke of luck? This is where the concept of the Information Ratio becomes important. It helps investors understand how skillfully a fund manager delivers those excess returns compared to the risk taken.

Most investors are familiar with the Sharpe Ratio, which compares a fund’s return to the risk-free rate. However, the Information Ratio is different. It compares the fund’s return to its benchmark and considers how consistently the fund has outperformed that benchmark. The key difference is that it focuses on the active return (the amount by which a fund beats its benchmark) and the tracking error (how much that active return fluctuates).

In simple terms, the Information Ratio tells you how much additional return a fund manager has delivered for every unit of risk taken by deviating from the benchmark. A higher Information Ratio indicates that the manager is not only beating the benchmark but doing so consistently and efficiently.

So why does this matter to investors?

Let’s say you are evaluating two Large-Cap equity funds. Both have outperformed their benchmark index by 3 per cent over the past year. But one of them has done so with sharp swings and inconsistent monthly performance, while the other has delivered that 3 per cent more steadily. The second fund is clearly more dependable. The Information Ratio captures this difference. It essentially rewards fund managers who consistently deliver alpha with controlled risk.

Consider a real-world example. An actively managed fund delivers a 14 per cent return in one year, while the benchmark returns 11 per cent. This 3 per cent outperformance is the active return. Now, if the fund has done this with minimal fluctuations and with a relatively steady strategy, its Information Ratio would be high, signalling strong and repeatable performance. On the other hand, if that outperformance came with erratic returns and high volatility, the Information Ratio would be lower, raising doubts about sustainability.

How should you interpret the numbers?

An Information Ratio above 1 is considered excellent, between 0.5 and 1 is good, and below 0.5 may indicate the fund is either too similar to the index or lacks consistent alpha generation. A negative Information Ratio suggests underperformance and may not justify the fees charged by an active fund.

The Information Ratio is particularly useful when comparing funds with similar mandates. It helps separate skilled fund managers from those who may have simply benefited from short-term market movements. While it should not be the sole factor in your decision, it certainly adds depth to your fund evaluation process.

In an age where many funds track their benchmarks closely but still charge active management fees, the Information Ratio shines a light on who is truly earning that fee. The next time you review a factsheet, go beyond return percentages. Look at how consistently those returns were delivered. That’s where the Information Ratio becomes your trusted guide!