Understanding Information ratio in mutual funds: Calculation, formula and significance

The Information ratio is a risk-adjusted performance metric that measures how consistently a fund manager generates excess returns compared to a benchmark. It helps you determine whether a mutual fund's outperformance is due to the fund manager's active selection or simply market movements.

Let's understand the meaning of the Information ratio, how it is calculated and how to interpret it.

What is Information ratio?

Information ratio shows a fund manager's ability to generate returns above a benchmark index relative to the level of active risk taken.

In simple terms, it evaluates whether the excess return earned by a mutual fund justifies the volatility associated with deviating from the benchmark. It is typically useful to analyze the performance of equity mutual funds, index funds or ETFs.

The Information ratio is particularly valuable when evaluating funds within the same category. A fund with a higher Information ratio reflects better risk-adjusted performance and more effective active management.

How is it different from Sharpe ratio and Alpha?

Unlike the Sharpe ratio, which compares returns against total portfolio risk, the Information ratio focuses specifically on the risk arising from the fund manager's investment decisions. In other words, the Sharpe ratio evaluates returns per unit of total risk, whereas the Information ratio evaluates excess returns per unit of active risk.

Alpha measures the absolute return by which a fund has outperformed its benchmark, whereas Information ratio measures the excess return generated relative to the active risk taken.

However, Alpha only highlights the magnitude of the excess return and does not account for the consistency or risk involved in generating that outperformance. The Information ratio addresses this limitation by incorporating tracking error into its formula, thereby evaluating how efficiently and consistently the excess returns have been achieved.

How is the information ratio calculated?

The Information ratio is calculated using the following formula:

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

where,

• Portfolio Return is the annualized return generated by the mutual fund in a specific period.
• Benchmark Return is the annualized return of the benchmark index in a specific period.
• Tracking Error (or standard deviation of excess returns) shows the volatility of the fund's returns relative to the benchmark.

How to interpret Information ratio?

Suppose Fund A generated an annualized return of 13%, while its benchmark delivered 11% during the same period. The excess return is therefore 2%.

If the tracking error of the fund is 1%, the Information ratio would be 2. An Information ratio of 2 indicates that the fund generated 2% of excess return for every 1% of active risk taken.

Now consider Fund B, which generated an annualized return of 14% compared to the benchmark's 11%. Although Fund B's excess return is higher at 3%, its tracking error is also 3%. The Information ratio of Fund B will be 1.

An Information ratio of 1 means Fund B generated only 1% of excess return for every 1% of active risk taken.

Although Fund B delivered a higher return than Fund A, Fund A has a higher Information ratio. The higher Information ratio suggests that Fund A generated its excess returns more efficiently and with better control over active risk.

Also, Fund A's higher Information ratio suggests that its outperformance is more likely attributable to the fund manager's ability to generate excess returns.

On the other hand, Fund B's outperformance over the benchmark may be partly due to greater risk-taking or to market movements.

Other cases of Information ratio

1. Assume a fund generated a negative return of 10% over the last five years, while its benchmark delivered a negative return of 4%. If the tracking error is 12%, the Information ratio would be -0.5.
   
   Even though both the fund and the benchmark index gave negative returns, the fund performed worse. The negative ratio suggests that the manager's active decisions did not add value and may have contributed to the underperformance.
2. Suppose a fund delivered a negative return of 4% over the last five years, while the benchmark declined by 8%. With a tracking error of 5%, the Information ratio equals 0.8.
   
   Despite generating negative returns in absolute terms, the fund outperformed the benchmark. This positive Information ratio indicates that the fund manager was able to limit losses more effectively than the market and add value through active management.

Benefits of Information ratio

1. It evaluates how consistently a fund generates returns above its benchmark rather than focusing only on absolute returns.
2. Investors can use it to compare funds within the same category and analyze the performance across different market conditions.
3. The ratio considers the risk taken to achieve excess returns, providing a more balanced view of performance.

Limitations of the Information ratio

1. An inappropriate selection of benchmarks can distort the ratio and lead to misleading conclusions about fund performance.
2. Limited historical data can result in unstable ratios that do not accurately reflect a fund manager's performance.
3. The metric focuses on tracking error and may overlook significant losses caused by rare market events.

Disclaimer: This is purely for educational/ informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.