Information Ratio Formula

Information Ratio Formula (Table of Contents)

Information Ratio Formula
Examples of Information Ratio Formula (With Excel Template)
Information Ratio Formula Calculator

Information ratio, also known as appraisal ratio is one of the most important ratios used in active management strategy. Information ratio basically measures the return of the portfolio over and above the return of the benchmark compared that return with the volatility of those returns. Benchmark here is usually an index which is a representation of the market. In other word, the information ratio is risk-adjusted return relative to benchmark return. Information ratio is used to measure the performance, skills, and ability of portfolio managers to generate a return over the benchmark. It is also used to measure the consistency in that performance by using tracking error. Tracking error is basically a standard deviation of the excess return. A low tracking error signifies portfolio is generating returns over benchmark consistently over time and high tracking error indicates that returns are very volatile and not very consistent.

Information ratio is very similar to Sharpe ratio but the difference between these two is that benchmark in Sharpe ratio is risk-free rate whereas in Information ratio, it the benchmark’s expected return. So if the benchmark is the same as the risk-free rate, both ratios will be the same.

Information ratio helps us in comparing different funds by standardizing the returns. The formula for Information ratio is given by:

Information Ratio = (Portfolio Return – Benchmark Return) / Tracking Error

Portfolio Return = Portfolio return for the period
Benchmark Return = Return on the fund used as a benchmark
Tracking Error = Standard deviation of the difference between the portfolio and benchmark returns

Examples of Information Ratio Formula (With Excel Template)

Let’s take an example to understand the calculation of the Information Ratio in a better manner.

You can download this Information Ratio Template here – Information Ratio Template

Information Ratio Formula – Example #1

Let say you have some amount of money which you have saved and want to invest that now in the market. You have down selected 2 funds A and B in which you want to invest but now you are confused to choose one among them. To do that, you have decided to compare the Information ratio of both the funds. You have used the S&P 500 index as a benchmark.

Solution:

Information Ratio is calculated using the formula given below

Information Ratio = (Portfolio Return – Benchmark Return) / Tracking Error

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For A

Information Ratio = (15% – 7%) / 10%
Information Ratio = 8% / 10%
Information Ratio = 0.8

For B

Information Ratio = (12% – 7%) / 4%
Information Ratio = 5% / 4%
Information Ratio= 1.25

On face value, it seems that fund A is better than fund B but information ratio of B is higher than A. This is an indication that Fund B is more consistent in generating excess returns, as compared to the Fund A.

Information Ratio Formula – Example #2

Let take Google as an example and calculate the information ratio using the public data available. We are taking the S&P 500 index as a benchmark.

Solution:

Take the historical share price of Google on a monthly basis and calculate the year on year return.

Perform the same activity with the Rest of Google Price and with S&P index also.

Average Return for Both Google and S&P index is calculated as

Rp – Average Return of Google

Rb – Average Return of S&P

For calculating the tracking Error, we have to calculate the Difference of both the returns.

Similarly for the other data.

Tracking Error is calculated as

Information Ratio is calculated using the formula given below

Information Ratio = (Portfolio Return – Benchmark Return) / Tracking Error

Information Ratio = (1.14% – 0.54%) / 2.90%
Information Ratio = 0.60% / 2.90%
Information Ratio = 0.21

Explanation

There are two types of investment strategies which investors can adopt: Active Management and Passive management. In Active management, an investor tries to beat the benchmark and tries to obtain return over and above benchmark returns. On the other hand, in passive management, investors usually try to mimic the performance of the benchmark or invest in the benchmark itself. Portfolio managers who are using active management strategy usually have to put many efforts into achieving those returns. So they charge hefty fees for management. But it is really necessary to keep track of the excess return and also the consistency of that.

Information ratio helps us in measuring the success of an active management strategy. It takes into consideration the excess returns over the benchmark along with the standard deviation of those excess return. It helps us to determine the consistency in the fund’s performance and make sure that those excess returns do not result in good luck.

Relevance and Uses of Information Ratio Formula

The information ratio is primarily used as a performance measure by fund managers. Since it not only takes the return but also adjusts that with the volatility, it is more practical compared to Sharpe Ratio. The general rule of thumb is that higher the Information ratio, better is the performance and consistency. If IR is negative, it means that the portfolio manager is not even able to achieve the benchmark return, let alone the excess return. But sometimes, different investors interpret Information ratio differently. This depends upon the fact that what level of risk tolerance the investor has. Various factors like age, goals, needs, etc. will determine the risk appetite of investor and these parameters vary investor to investor. So other financial ratios along with information ratio should also be looked at before taking any decision