Investing by considering only historical returns in a mutual fund scheme is risky. Investors need to evaluate the risk involved in mutual fund schemes before investing. In this article we will cover significance of Information Ratio.
Information Ratio
Definition:
The Information ratio is a measure of the risk-adjusted return of a financial security (or asset or portfolio). It is also known as Appraisal ratio.
Information ratio is expected active return divided by tracking error, where active return is the difference between the return of the security and the return of a selected benchmark index, and tracking error is the standard deviation of the active return
The information ratio (IR) IR is advanced version of Sharpe Ratio. Sharpe ratio is the excess return of an asset over the return of a risk free asset divided by the variability or standard deviation of returns, the information ratio is the active return to the most relevant benchmark index divided by the standard deviation of the "active" return or tracking error.
Computation:
(Annualized Rp – Annualized Ri) /Standard Deviation of Monthly (Rp – Ri) * 3.4641)
A common mathematical definition of the information ratio for a portfolio is the excess returns of the portfolio over the predefined benchmark divided by the standard deviation of those excess returns, or the tracking error.
The information ratio is often annualized.
Significance
· The information ratio is often used to gauge the skill of managers of mutual funds. It measures the expected active return of the manager's portfolio divided by the amount of risk that the manager takes relative to the benchmark.
· The higher the information ratio, the better is the performance of the fund manager.
· Information ratio is useful in comparing a group of funds with similar management styles.
· Information ratio shows the consistency of the fund manager in generating superior risk adjusted performance
We will explain Sortino Ratio and its significance in the next article.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.