Mastering Investment with Information Ratio

Information Ratio helps in navigating the complexities of the investment landscape by assessing an active fund manager’s performance. And though it has its limitations, it remains an essential part of the finance industry. The article explains what Information Ratio is and how investors can use it as another tool 

One of the widely accepted facts among investors now is that mutual funds can be a powerful tool for wealth creation, especially when it concerns retail investors. This is evident from the substantial monthly inflows into equity mutual fund schemes over the past few years. In June 2024 alone, inflows, including a few new fund offers, surpassed ₹40,000 crore. SIP contributions also remained robust, exceeding ₹21,000 crore. However, another set of data tells a different story. According to the Association of Mutual Funds in India (AMFI), 49.74 lakh new SIP accounts were registered in May 2024 as compared to 63.65 lakh in April. Moreover, SIP discontinuations rose by 32.21 per cent, reaching 43.96 lakhs in May from 33.25 lakhs in the previous month. 

Consequently, the SIP stoppage ratio, which measures the number of SIPs discontinued or expired as a percentage of new SIPs registered, hit 88.38 per cent in May, surpassing the previous high of 80.69 per cent in May 2020. One of the reasons that investors are currently cautious in their approach is that they are waiting for the air to be clear of the uncertainty around higher market valuation and the election outcome, including the Union Budget. However, long-term investors should avoid trying to time the market and instead focus on honing their fund selection skills. An important metric in this regard is the Information Ratio, which measures investment performance. 

Defining Information Ratio
Information Ratio is a popular and widely used performance measure. It was originally developed as Appraisal Ratio. Information Ratio indicates how much additional excess return over the benchmark can be obtained per additional unit of risk. Therefore, it is able to quantify how much value is added or destroyed by an active manager. For example, an active manager usually has some expectations about future stock price developments. He will use this information to overweight or underweight certain stocks relative to the market portfolio, and thereby incur additional risks relative to the market. 

Through the use of Information Ratio, the investor is able to see how much additional return has been generated by an active fund manager in relation to the additional risks he had to incur in order to implement his superior information by overweighting or underweighting certain stocks. This is also the reason why this ratio is called Information Ratio – it measures the quality of the manager’s ‘superior’ information. If we take different funds in the Large-Cap category, these have different weightage to different stocks, indicating different views of fund managers on different stocks. 

For example, ICICI Prudential Blue Chip Fund had the maximum weightage to ICICI Bank of 8.19 per cent at the end of June 2024. ITI Large-Cap Fund in the same period has given 6.06 per cent weightage to ICICI Bank. Compare these with JM Large-Cap Fund, which has only allotted 3.29 per cent of the entire corpus towards ICICI Bank. They are all large-cap funds and have a similar benchmark i.e. Nifty 100–TRI and BSE 100– TRI where the weightage of ICICI Bank is 6.4 per cent. So, we see that different fund managers, depending upon their information and future outlook about the stock, allot different weightage to different stocks. This information and a fund manager’s views help him to create alpha for the investors. 

Calculating Information Ratio
To calculate the Information Ratio, follow these steps:
1. Collect Returns - Gather the daily, weekly or monthly returns of the fund and the benchmark for a specified period.
2. Calculate Excess Returns - Find the difference between the fund returns and the benchmark returns. This difference is known as the excess return.
3. Average Excess Return - Compute the average of these excess returns over the given period.
4. Standard Deviation of Excess Returns (Tracking Error) - Calculate the standard deviation of the excess returns, which measures how much these returns deviate from their average. This is also known as tracking error.
5. Compute the Information Ratio - Divide the average excess return by the standard deviation of the excess returns. 

In formula terms, Information Ratio is the average excess return divided by the volatility (standard deviation) of the excess return. Higher average excess returns and lower volatility are desirable, so a higher Information Ratio indicates better performance. The following table shows the Information Ratio of some of the large-cap funds. To calculate Information Ratio, we have taken the weekly returns of funds since their inception following which we have annualised the Information Ratio. 

Negative Excess Returns
However, Information Ratio has a flaw. The main problem associated with Information Ratio is that it fails to take into account portfolios that do better per unit of risk if their results are below the benchmark. The following example will illustrate this. Fund A has a 10-year annualised excess return of –2.74 per cent and tracking error (or standard deviation of excess returns) of 4.26 per cent. With these two values, the Information Ratio for Fund A works out to –0.64. Now take another fund. Fund B has a 10-year annualised excess return of –6.87 per cent and tracking error of 11.58 per cent, resulting in an Information Ratio of –0.59. 

Since Fund B has the higher Information Ratio, one would think that this is the better of the two funds. However, Fund A has higher excess return and lower standard deviation, which by real world standards means that Fund A is the more promising stock. As we can see, there is a serious flaw with the Information Ratio when the excess returns are negative. The so-called Geometric Information Ratio is the way out of this discrepancy. Geometric Information Ratio uses the geometric mean of returns instead of arithmetic mean. Or, you can also use beta in the calculation of Information Ratio when the excess returns are negative. 

Beta is a measure of how sensitive a fund is to the benchmark. For instance, if a fund has beta of 0.9, then for every 1 per cent return that the benchmark has, the fund will have 0.9 per cent return. So, if the market moves up 20 per cent, this fund will move up 18 per cent. Therefore, it makes sense to use beta as a variable in determining the Information Ratio since both beta and the Information Ratio are comparing a fund to a benchmark. By using beta instead of tracking error in the exponent of the denominator, there is a better measure of how the stock and the benchmark are related. 

Since the goal of the information is to show how well or poorly a manager is performing compared to a benchmark, it is a reasonable assumption to use a variable that measures that relationship. Beta is the perfect choice. The following table highlights the Information Ratio and Geometric Information Ratio of some of the large-cap funds along with their returns and the period. The table shows that a higher Information Ratio does not necessarily mean higher returns. Often, annualised Information Ratio is used to rank the managers. This comparison is effective when managers have the same length of performance history. 

However, adjustments may be needed when comparing managers with different lengths of performance history. For example, comparing a manager’s annualised Information Ratio over 10 years to another manager’s Information Ratio over 3 years may not be accurate for two reasons: a) the excess returns could have been earned under different market conditions, and b) a shorter track record offers less statistical confidence in the results. It’s important to examine the consistency of Information Ratio across different periods to better understand a fund manager’s performance. 

Using Information Ratio Smartly
In conclusion, Information Ratio is a valuable tool for assessing investment performance. By considering the expected return, benchmark return and tracking error, it offers meaningful insights into the risk-adjusted returns of an investment strategy. Knowing how to calculate and interpret Information Ratio helps investors make informed decisions and distinguish between skilled portfolio managers and those who are simply lucky. However, investors should not rely solely on any single measure. Like any statistic based on historical data, a high Information Ratio in the past does not guarantee a high one in the future, and vice versa. 

Additionally, Information Ratio can be manipulated. While the choice of the annualisation method typically has a minor impact, the choice of benchmark can make a significant difference. Always interpret a published Information Ratio cautiously and be sceptical of any that use an inappropriate benchmark. Ultimately, regardless of the evaluation tool you use, the principle remains the same: a thorough assessment involves multiple tools and tests. As a diligent investor, you should adopt a comprehensive approach to evaluating investments. However, even though Information Ratio has its limitations, it remains an essential part of the finance industry. 

You can leverage the Information Ratio as a helpful metric when evaluating mutual funds. Remember to combine it with other factors like expense ratio, investment objectives, and past performance. Ensure the chosen benchmark accurately reflects the mutual fund's investment style and risk profile.