What is Information Ratio?
The Information Ratio quantifies the excess portfolio returns over the returns of a benchmark, relative to the volatility of the excess returns.
In short, the information ratio represents the excess return over a benchmark – most often the S&P 500 – divided by a tracking error, which is a measure of consistency.
How to Calculate Information Ratio
The information ratio (IR) measures the risk-adjusted returns on a portfolio in relation to a specified benchmark, which is normally an index representing the market (or sector).
The term frequently comes up when discussing active management (i.e. hedge fund managers) and judging their ability to generate consistent excess returns on a risk-adjusted basis.
The usage of a tracking error – i.e. the standard deviation of the portfolio and the performance of the chosen index, such as the S&P 500 – in the calculation considers the consistency of the returns to ensure a sufficient time frame (and different economic cycles) are considered, not just one outperforming or underperforming year.
- Low Tracking Error → Less Volatility and Consistency in Portfolio Returns Exceeding the Benchmark
- High Tracking Error → High Volatility and Inconsistency in Portfolio Returns Exceeding the Benchmark
In short, the tracking error reflects how the performance of a portfolio deviates from the selected benchmark’s performance.
Portfolio managers that actively manage a portfolio strive to achieve a higher information ratio, as it implies consistent risk-adjusted returns in excess of the set benchmark.
Below are the steps to calculate the information ratio:
- Calculate the Portfolio Return for a Given Period
- Subtract the Portfolio Return by the Tracked Benchmark Index Return
- Divide the Resulting Figure by the Tracking Error
- Multiply by 100 to Express as a Percentage
Information Ratio Formula
The formula for calculating the information ratio is as follows.
Where:
- Excess Return → The numerator of the ratio, i.e. the excess return, is the difference between a portfolio manager’s returns and that of the benchmark.
- Tracking Error → The denominator, i.e. the tracking error, is a less straightforward calculation, as the standard deviation captures the volatility of the excess return.
