Understanding the Information Ratio
The information ratio is a financial metric used to evaluate fund performance. It is calculated by subtracting the benchmark return from the portfolio return and then dividing the result by the tracking error. This ratio is particularly useful for assessing slightly active funds. A higher information ratio indicates that a fund manager is consistently generating returns above the benchmark.
Here’s a simple explanation of tracking error: it shows how much a fund’s returns go up or down compared to its benchmark, helping to understand how closely the fund follows the benchmark. The formula for tracking error is: Tracking Error = Standard Deviation (Portfolio Return – Benchmark Return)
Interpreting the Ratio
A positive difference between portfolio return and benchmark return is favourable. If this difference is at least half the tracking error, it suggests strong performance (Information ratio > 0.5). On the other hand, a negative information ratio indicates that the fund has failed to outperform its benchmark. This metric serves as a tool for comparing the effectiveness of different funds.
Example:
Let’s say a portfolio has an annual return of 12%, its benchmark has an annual return of 10%, and the tracking error is 4%.
Information Ratio = (12%−10%)/4% = 2%/4% = 0.5
An information ratio of 0.5 suggests that the portfolio generated 0.5 units of excess return for every unit of tracking error.
Top performing funds by information ratio for 5 years
Application to Recent Data
Analyzing five-year data from the period following the COVID-19 downturn reveals that many funds show positive numbers. However, within these positive figures, some funds exhibit an information ratio above 0.5, indicating better outcomes. Others have ratios near zero, suggesting less impressive performance. This demonstrates the utility of the information ratio in distinguishing between varying levels of fund success.
What’s the information ratio of your portfolio? Is it above 0.5? Share your thoughts in the comments below! Thanks for reading, and if you found this blog helpful, don’t forget to share it with your friends!
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