What is Information Ratio (IR)
The information ratio (IR) is a measure 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 it also attempts to identify the consistency of the investor.
BREAKING DOWN Information Ratio (IR)
The information ratio identifies how much a manager has exceeded the benchmark. Higher information ratios indicate a desired level of consistency, whereas low information ratios indicate the opposite. Many investors use the IR when selecting exchange-traded funds (ETFs) or mutual funds based on investor risk profiles. Although compared funds may be different in nature, the IR standardizes the returns by dividing the difference by the standard deviation:
Rp = Return of the portfolio
Ri = Return of the index or benchmark
Information Ratio vs. Sharpe Ratio
Like the information ratio, the Sharpe ratio is an indicator of risk-adjusted returns. However, the Sharpe ratio is calculated as 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 IR aims to measure the risk-adjusted return in relation to a benchmark, such as the Standard & Poor's 500 Index (S&P 500), and it measures the consistency of an investment's performance. However, 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 that, on a risk-adjusted basis, a manager has produced better returns compared to a manager with a lower ratio.
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%. Also, assume the index has an annualized return of -1.5%. Manager A's IR is 1.81 (13 - (-1.5) / 8) and Manager B's IR is 2.11 (8 - (-1.5) / 4.5). Although manager B had lower returns, his portfolio had a better IR.