The information ratio is a risk-adjusted performance metric often utilized when evaluating mutual funds. The information ratio takes into account both the risk-free return rate and the return on the benchmark portfolio, giving investors a better understanding of the how much risk the manager took to acheive its performance.
Q. This one sounds like some sort of technology or high frequency trading term, but it’s actually very common way of evaluating mutual fund managers, right?
A. Yes. This is another one of the performance metrics people use to judge investment manager performance. It’s in the same family as Sharpe Ratio, Sortino Ratio, and Calmar Ratio, but is a little bit different, and better in certain cases.
Q. OK. We often say that Sharpe is a measure of return per unit of risk. How is Information Ratio different than that?
A. The easiest way to understand it is to think of return in three buckets: risk-free return; beta return; and alpha. The Sharpe ratio strips out the risk-free return and compares the combination of alpha and beta returns to risk taken. The Information Ratio is a bit more precise: it strips out both risk free and beta returns, and focuses just on how much risk was taken to achieve the alpha component of the return.
Q. And what sorts of situations do you want to look at the Information Ratio?
A. The best use is in measuring an active manager versus a given index. So, for example, it’s a great way of comparing different mutual fund managers who are in the same sector, like S&P large caps. That’s where most investors are likely to have seen this statistic; the higher the information ratio, the better. A good information ratio is, say, something north of .5, and higher is better. Remember that with Sharpe Ratios, though, we’re looking for something higher than 1.
Q. So its great in measuring performance against a given stock index. When isn’t it so great?
Q. It’s based on a theory about normalized risk distribution, so it’s not so useful for hedge funds playing asymmetric risks, like global macro funds. And of course it makes no sense for absolute return funds, which by definition are not tied to a given index.