Information ratio (IR) or Appraisal Ratio is defined as a mathematical measure used to determine the consistency of a fund manager to provide investors with risk-adjusted returns over the long term. A higher ratio typically represents the ability of a fund manager (mutual fund scheme) to outperform other fund managers or the benchmark, over a specific period of time. In most cases, the IR value is annualized similar to longer-term returns data to facilitate an easier understanding. It should be noted that using the Information Ratio is most effective when the funds or portfolio of similar type are compared to each other.
Calculation of Information Ratio
Information ratio of a mutual fund or investment portfolio is calculated using the following formula:
IR = (R-BR)/w
IR = Information Ratio
R = Scheme/Portfolio Returns
BR = Benchmark returns
Therefore, (R-BR) = Active returns of the fund/portfolio.
w = Standard deviation of the active return i.e. tracking error of the scheme.
- Standard deviation helps measure the level of risk associated with the investment. Higher the Standard deviation, lesser the consistency or predictability.
- One may calculate the Tracking error by taking the standard deviation of the difference between the portfolio returns and index returns.
Key Features of Information Ratio
- Information Ratio helps in the determination of how much and how often a portfolio trades in excess of its benchmark. The IR calculation helps provide a quantitative result of the performance of your fund management.
- Comparison to benchmark i.e. tracking error data used to calculate the ratio takes into account the ability of the fund/fund manager to provide returns that exceed benchmark returns. Changing benchmark will lead to a change in the ratio of the scheme.
- The ratio data is based on the historical performance of the scheme and there is no guarantee that similar levels of performance will be maintained at a later date.
Advantages of Information Ratio
The following are some key pointers to keep in mind when selecting a mutual fund to invest in, based on this ratio:
- A consistently high Information Ratio over the longer-term represents a fund’s and the fund manager’s ability to outperform the chosen benchmark. Such consistency allows the investors to invest in/redeem their investments without the need to time markets, thereby attracting them towards the specific funds.
- Appraisal Ratio not only measures and compares returns but also adjusts results according to the market volatility.
Limitations of Information Ratio
While the Appraisal Ratio considers the consistency of returns that a mutual fund or investment portfolio has provided to its investors as a mathematical function, the calculation does not take scheme leverage into account. As a result, the Appraisal Ratio may provide negative returns when the fund generates a high alpha in comparison to the benchmark and vice versa. This is the key reason as to why you should not base your investment decision on a single criteria or performance metric in case of any scheme.
Information Ratio vs. Sharpe Ratio
As mentioned earlier, the Information Ratio provides details of the active returns of a scheme i.e. the scheme’s performance with respect to its chosen benchmark divided by the standard deviation. On the other hand, the Sharpe ratio represents the “excess” returns or outperformance provided by a scheme when compared to the returns provided by a risk-free investment divided by the standard deviation of returns. The Sharpe Ratio can be calculated as the difference between the asset’s return and the risk-free rate of return divided by the standard deviation of the asset’s returns. As a result of the use of benchmark comparison criteria, Information Ratio can often provide a better representation of a scheme’s past performance as compared to Sharpe Ratio. One should, however, utilize multiple comparison criteria rather than depending on a single one when comparing or choosing investments.