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 annualised similar to longer term returns data to facilitate easier understanding. It is notable that using information ratio is most effective when funds or portfolio of similar types 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.
Advantages of Information Ratio in Mutual Fund Selection
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 by extension the fund manager’s ability to outperform the chosen benchmark. Such consistency is desirable for investors as it allows them to invest in/redeem their investments without need to time markets.
- Appraisal ratio not only measures and compares returns but also adjusts results according to the market volatility.
Important points to note about Information Ratio
- 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 historic performance of the scheme and there is no guarantee that similar levels of performance will be maintained at a later date.
Limitations of Information Ratio
While appraisal ratio does consider consistency of returns that a mutual fund or investment portfolio has provided to its investors as a mathematical function, the calculation does not take into account scheme leverage. As a result, the appraisal ratio calculation may provide negative returns when the fund generates a high alpha in comparison to the benchmark and vice versa. This is the key reason 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, 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 standard deviation. On the other hand, 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. 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, utilise multiple comparison criteria rather than depending on a single one when comparing or choosing investments.