information ratio
The Information Ratio is a performance measure used to assess the value added by an investment manager or portfolio relative to a benchmark, taking into account the level of active risk taken. It evaluates the manager’s ability to generate excess returns through the use of available information.
The Information Ratio is calculated by dividing the manager’s excess return (the difference between the portfolio return and the benchmark return) by the tracking error (the standard deviation of the excess return). The formula for the Information Ratio is as follows:
Information Ratio = Excess Return / Tracking Error
where:
- Excess Return is the difference between the portfolio return and the benchmark return. It represents the value added or subtracted by the investment manager through active investment decisions.
- Tracking Error is the standard deviation of the excess return, which measures the volatility or variability of the manager’s active investment strategy relative to the benchmark.
The Information Ratio provides a measure of the manager’s ability to generate excess returns on a risk-adjusted basis. It indicates the level of value added by the manager per unit of tracking error. A higher Information Ratio suggests better performance, as it indicates that the manager has generated a higher level of excess return relative to the level of tracking error.
The Information Ratio is particularly useful in evaluating actively managed portfolios or investment strategies, where the manager seeks to outperform a specific benchmark through active decision-making. It helps investors and analysts assess the manager’s skill in identifying and exploiting information advantages.