What is the 'Information Ratio - IR'
The information ratio (IR) is a ratio of portfolio returns above the returns of a benchmark -- usually an index -- to the volatility of those returns. The information ratio (IR) measures a portfolio manager's ability to generate excess returns relative to a benchmark but also attempts to identify the consistency of the investor.
Rp = Return of the portfolio
Ri = Return of the index or benchmark
Sp-i = Tracking error (standard deviation of the difference between returns of the portfolio and the returns of the index)
BREAKING DOWN 'Information Ratio - IR'The information ratio identifies whether a manager has beaten the benchmark by a lot in a few months or a little every month. The higher the IR, the more consistent a manager, with consistency being an ideal trait. Conversely, the lower the IR, the less consistency. The IR serves as a tool that investors use when selecting exchange-traded funds (ETFs) or mutual funds based on investor risk profiles. Although the funds being compared may be different in nature, the IR standardizes the returns by dividing the difference by the standard deviation.
Information Ratio vs. Sharpe Ratio
The Sharpe ratio is similar to the IR and is used to measure risk-adjusted returns. However, the Sharpe ratio measures the difference between an asset's return and the risk-free rate of return divided by the standard deviation of the asset's returns. The difference between the Sharpe ratio and the IR is that the IR aims to measure the risk-adjusted return in relation to a benchmark, such as the Standard & Poor's 500 Index (S&P 500). Additionally, the IR measures the consistency of an investment's performance, while the Sharpe ratio measures how much an investment portfolio outperformed the risk-free rate of return on a risk-adjusted basis.
A high IR can be achieved by having a high return in the portfolio, a low return of the index and a low tracking error. A high ratio means a manager can achieve higher returns more efficiently than one with a low ratio by taking on additional risk. Additional risk can be achieved through leveraging.
For example, assume fund manager A has an annualized return of 13% and a tracking error of 8%, while fund manager B has an annualized return of 8% and tracking error of 4.5%, and the index has an annualized return of -1.5%. Therefore, manager A's IR is 1.81, or 13 - (-1.5) / 8 and manager B's IR is 2.11, or 8 - (-1.5) / 4.5. Although manager B had lower returns, the portfolio has a better IR.