Information Ratio: Definite Guide on How To Use It

With the maturity of the mutual fund market comes various ways of assessing their performance both in historical terms and even trying to predict future returns. There are a plethora of ratios used to correctly identify the performance of schemes. One of them is Information Ratio which is also known as Appraisal ratio. This is a measure of the risk-adjusted return of a portfolio and is calculated by dividing the portfolio’s mean excess return relative to its benchmark by the variability of that excess return. The mean excess return is defined as the difference between the return of the security and the return of a selected benchmark index, and variability of excess return is the standard deviation of the active return.

A different form of the information ratio is also used, one that measures that part of the performance that comes from fund manager’s bet on a stock that does not form part of the benchmark, such as idiosyncratic risk. Whichever variant you use, information ratio tells an investor how much excess return is generated by the scheme from the amount of excess risk taken relative to the benchmark. Information ratio is presented in annualised.

The ratio also helps to gauge the skill of fund managers. Higher the information ratio better the performance of fund manager. It signifies fund manager’s knack of picking right stocks that have helped it to outperform the benchmark without taking the commensurate risk. It answers the question of how much reward a manager generated in relation to the risks he or she took deviating from the benchmark.

How does an investor know whether an information ratio of a fund is “good” or “bad”? A simple rule of thumb is that higher is better. In general, top quartile fund manager has information ratio of 0.5 or higher. However, the information ratio should always be used to compared fund managers following the same style of investment rather than different styles. One more thing to watch is how long this information ratio is available. The longer the better as it will help to assess the persistence of manager’s performance. Moreover, it also gives credence to the ratio as a short history of the fund may be subject to estimation uncertainty and its statistical significance.

Information ratio, though, not used widely in India as used in developed markets, if used properly will help an investor to identify performing active fund manager and invest accordingly.