What is the information ratio in mutual funds and why is it important?

When selecting a mutual fund, investors often focus chiefly on its historical returns. It may seem that the higher the returns, the better the scheme’s performance, but that’s only half the picture.

A more complete assessment of a fund’s performance and return potential comes when you factor in how much risk the fund took to achieve those returns. This is where risk-adjusted return metrics come into play.

Risk-adjusted metrics provide a comprehensive view of the fund’s performance by helping investors understand whether the fund manager took disproportionate risks to earn those returns. This, in turn, can help investors compare the performance of two funds more holistically and see which one had a more optimal risk-return balance. This balance is important because a turbulent investment experience can cause undue stress to the investor, irrespective of the eventual returns.

There are several metrics for risk-adjusted returns, including alpha, standard deviation, Sharpe ratio and information ratio. This article focuses on information ratio, explaining what it is, how it is calculated and why it is important when evaluating a mutual fund scheme’s performance.

• Table of contents

1. What is information ratio (IR)?
2. How is information ratio calculated?
3. How is information ratio useful?
4. What are the various uses of the information ratio?
5. What are the limitations of the information ratio?
6. What’s the difference between information ratio and Sharpe ratio?

What is the Information Ratio (IR)?

Information ratio helps investors understand how well a fund is doing relative to the market, after accounting for the risk involved. More specifically, it tells you how much excess return a fund is generating for every unit of risk it takes, compared to a benchmark index.

This is an especially useful metric for actively managed funds, as it helps you assess if the decisions made by the fund manager are resulting in superior returns without entailing disproportionate risk.

A high Information Ratio indicates that the fund has outperformed the benchmark without taking undue risk, while a low ratio indicates that the fund has taken a lot of risks but has not delivered enough returns to justify that risk.

How is the Information Ratio Calculated?

The formula for calculating the Information Ratio is fairly straightforward:

Information Ratio (IR) = (Fund Return – Benchmark Return) / Tracking Error

Here’s a breakdown of each component:

• Fund Return: This is the return generated by the fund over a specific period.
• Benchmark Return: This is the return generated by the benchmark index (like the Nifty 50) over the same period.
• Tracking Error: This measures how closely the fund’s returns have matched the benchmark index. It is the standard deviation of the difference between the fund’s returns and that of its benchmark. A low tracking error indicates a close correlation between the fund and benchmark returns. A higher tracking error indicates greater divergence, which means greater risk.

How is the Information Ratio Useful?

Imagine you are considering two mutual funds, Fund A and Fund B, both benchmarked against the Nifty 50 Index. Over the past year, Fund A has delivered a return of 12%, while Fund B has delivered 10%. During the same period, the Nifty 50 Index returned 8%.

Let’s assume the tracking error for Fund A is 2%, and for Fund B, it is 1%.

For Fund A:

• Excess Return = 12% - 8% = 4%
• Information Ratio = 4% / 2% = 2.0

For Fund B:

• Excess Return = 10% - 8% = 2%
• Information Ratio = 2% / 1% = 2.0

In this example, both Fund A and Fund B have the same Information Ratio, even though Fund A has a higher return. This is because Fund B’s return, relative to its risk (measured by tracking error), is just as efficient as that of Fund A.

The Information Ratio helps you understand how efficiently the fund’s returns are being generated in relation to the risks taken.

What are the Various Uses of the Information Ratio?

The information ratio is a valuable tool for investors, especially when comparing mutual funds. The following are some of its uses:

1. Performance Evaluation: The Information Ratio helps you evaluate how well a fund manager is performing. If a fund has a high Information Ratio, it indicates that the fund manager is effectively generating returns above the benchmark, considering the risk involved.

2. Risk-Adjusted Returns: Unlike just looking at returns, the Information Ratio gives you a clearer picture by factoring in risk. This helps you identify funds that are not only performing well but are also managing risk effectively.

3. Fund Comparison: When choosing between multiple mutual funds, the information ratio allows you to compare how well each fund has so far* performed relative to its benchmark. This comparison can be helpful in making investment decisions. (*Past performance may or may not be sustained in the future.)

4. Long-Term Investment Decisions: Funds with a consistently high Information Ratio over time may be more reliable for long-term investments. This is because they tend to provide stable returns with a well-managed level of risk.

What are the Limitations of the Information Ratio?

Like with any financial metric, the Information Ratio has its limitations. It’s important to be aware of these when using it to make investment decisions. It’s also important to consider multiple parameters and ratios when choosing a scheme.

1. Focus on Relative Performance: The Information Ratio focuses only on relative performance against a benchmark and does not show the fund’s absolute returns. A portfolio could have a high Information Ratio but still deliver poor absolute returns if the benchmark itself performs poorly.

2. Dependence on Benchmark: The accuracy of the Information Ratio depends heavily on the chosen benchmark. If the benchmark is not well-matched with the fund’s strategy, the Information Ratio might not give an accurate picture of the fund’s performance.

3. Short-Term Volatility: The Information Ratio can be influenced by short-term market volatility, which might not be reflective of the fund’s long-term performance. This is especially true for funds with a high tracking error due to short-term fluctuations.

4. Does Not Account for Other Risks: The IR only considers the risk relative to the benchmark (tracking error) and does not take into account other types of risks, such as liquidity risk, credit risk, or market risk. This narrow focus can provide an incomplete picture of the portfolio's overall risk profile.

5. Complexity for Beginners: For new investors, understanding and using the Information Ratio might be a bit complex. It requires knowledge of concepts like tracking error and benchmark returns, which can be confusing at first.

What’s the Difference Between the Information Ratio and the Sharpe Ratio?

Another popular metric to measure risk-adjusted returns is the Sharpe Ratio. At first glance, they may seem similar, but there are significant differences between the two.

Here’s an overview of the differences:

	Information Ratio	Sharpe Ratio
Benchmark	Compares fund return to a specific benchmark index	Compares fund return to a risk-free rate (like government bonds)
Risk Measurement	Focuses on the tracking error	Focuses on the total risk (standard deviation of returns)
Usefulness	Best for comparing funds within the same category or with the same benchmark	Best for evaluating overall risk-adjusted return of a fund
Complexity	Slightly more complex due to the need for a benchmark	Simpler, as it only requires the risk-free rate and total return
Application	More relevant for relative performance evaluation	More relevant for absolute performance evaluation

Conclusion

The Information Ratio is a powerful tool for investors looking to evaluate the performance of mutual funds, ETFs, and fund managers. It provides insight into how well a fund is performing relative to a benchmark index while considering the risk involved. By understanding and using the Information Ratio, you can make more informed investment decisions, especially when comparing similar funds. At the same time, it’s important to remember that the Information Ratio is just one of many metrics. It should be used in conjunction with other tools and measures, like the Sharpe Ratio, to get a complete picture of a fund’s performance.

FAQs

What is Information Ratio?

The Information Ratio is a metric used to evaluate the performance of an investment portfolio or fund manager compared to a benchmark index, considering the risk taken to achieve that performance. In simple terms, it tells you how much excess return (above the benchmark) a portfolio generates for every unit of risk it takes.

What is a Negative Information Ratio?

A negative Information Ratio indicates that the fund is underperforming its benchmark.

How is the Information Ratio Beneficial for Investors?

The Information Ratio is beneficial because it helps investors identify funds that are generating excess returns relative to their benchmarks while also managing risk effectively. It’s a useful tool for comparing similar funds.

How is the Information Ratio Used to Compare Mutual Funds?

Investors use the Information Ratio to compare mutual funds by evaluating how well each fund performs relative to its benchmark. A higher Information Ratio suggests that the fund is delivering better risk-adjusted returns compared to others in its category.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.