Information Ratio
Candlefocus EditorThe information ratio is an important tool to measure a portfolio manager’s performance and is calculated by subtracting the return of a benchmark index from the return of the portfolio and dividing it by the volatility of the excess returns of the portfolio. The higher the information ratio, the better the portfolio manager is at generating returns in excess of the benchmark, given the risk taken. The ratio tells us how much more return a portfolio manager is getting for every unit of risk after accounting for the benchmark’s return.
To illustrate this, if a portfolio manager is achieving a 10% return in excess of a benchmark return of 8% and the volatility of the excess returns is 1%, then the information ratio calculation would look like this:
Information Ratio = (10% - 8%) / 1% = 2.
In this example, the information ratio of 2 is saying that the portfolio is achieving twice the return of the benchmark for each unit of risk taken.
The information ratio is a popular measure of portfolio manager performance because it takes into account both the return and the risk of a portfolio. A portfolio manager can generate a high return, but if too much risk is taken to achieve that return, then the information ratio will be lower. On the other hand, if a portfolio manager is able to generate a return with less risk than the benchmark then the information ratio will be higher.
When evaluating portfolio managers, it is important to look at the information ratio in addition to other performance measures such as return, beta and Sharpe ratio. While a high return may seem impressive, if it is not in excess of the benchmark and the risk taken is high, then the information ratio will be low. The information ratio helps to put returns into context and evaluate how well a portfolio manager is integrating risk into the portfolio. It is an important tool that should not be overlooked when evaluating a portfolio manager’s performance.