Information Ratio

The Information Ratio (IR) is a vital metric in finance, offering a lens to evaluate the risk-adjusted performance of an investment or portfolio. It goes beyond simple returns by comparing the excess returns of an asset or strategy to its tracking error, revealing whether the returns justify the risks taken. Whether you’re analyzing traditional asset classes or high risk digital currencies, understanding the Information Ratio can enhance your decision-making framework and provide clarity in assessing performance consistency.

It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

- George Soros

How to Calculate the Information Ratio?

To calculate the Information Ratio, you follow these steps:

Calculate the Portfolio’s Excess Return

\alpha = R_p - R_b

Where

$𝑅_𝑝$ is the return of the portfolio
$𝑅_𝑏$ is the return of the benchmark

Determine the Tracking Error

\sigma_{\alpha} = \sqrt{\frac{1}{N-1} \sum_{i=1}^{N} (\alpha_i - \overline{\alpha})^2}

Where

$\alpha_𝑖$ is the excess return in each period
$\overline{\alpha}$ is the average excess return
𝑁 is the number of periods.

Compute the Information Ratio

\text{IR} = \frac{\overline{\alpha}}{\sigma_{\alpha}}

Where:

$\overline{\alpha}$ is the average excess return (calculated in Step 1)
$\sigma_{\alpha}$ is the tracking error (calculated in Step 2)

Investments (11th Edition, 2018, McGraw-Hill Education) — Zvi Bodie, Alex Kane and Alan J. Marcus Quantitative Investment Analysis (4th Edition, 2020, CFA Institute) — Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto and David E. Runkle

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Strategy: Aim for an IR above 0.5 in trading; values above 1 are exceptional and indicate strong risk-adjusted performance.

Importance of the Information Ratio in Trading

The Information Ratio is important because it doesn’t just measure performance; it measures the consistency of performance relative to a benchmark. A high IR indicates that a portfolio manager is generating returns consistently above the benchmark, adjusted for the risk taken. This is invaluable for investors looking to evaluate the skill of a manager or the viability of a trading strategy.

Quantitative Investment Analysis (4th Edition, 2020, CFA Institute) — Richard A. DeFusco, Dennis W. McLeavey, Jerald E. Pinto and David E. Runkle

Comparing Two Portfolios

Let’s consider two portfolios, A and B, managed by two different fund managers. Both portfolios are benchmarked against the S&P 500 index.

Metric	Portfolio A	Portfolio B
Annualized return	12%	10%
Benchmark Return (S&P 500)	8%	8%
Tracking Error	5%	3%

Calculating Active Return

Active Return (A) = 12% - 8% = 4%

Active Return (B) = 10% - 8% = 2%

Calculating Information Ratio

IR (A) = 4% / 5% = 0.80

IR (B) = 2% / 3% = 0.67

Analysis: Despite Portfolio A having a higher return, its IR is only slightly better than Portfolio B’s. This is because Portfolio A’s returns come with higher volatility relative to the benchmark.

Combining Information Ratio with Other Tools

The Information Ratio is powerful on its own but gains even more insight when combined with other tools:

Sharpe ratio: While the Information Ratio compares returns to a benchmark, the Sharpe ratio compares returns to a risk-free rate. Together, they provide a fuller picture of risk-adjusted performance.
Alpha and Beta: Alpha measures the active return on investment, while Beta measures the sensitivity to market movements. Combining these with IR can help dissect performance drivers further.
Maximum Drawdown: This measures the maximum loss from a peak to a trough. It complements the IR by showing the worst-case scenario, enhancing risk management.

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Focus: Combine the IR with other metrics like Sharpe ratio to gain a comprehensive understanding of your trading strategy’s effectiveness.

Key Points

Measure of Active Management: The Information Ratio evaluates the effectiveness of an active manager by comparing the excess return (over a benchmark) to the additional risk taken.
Risk-Adjusted Outperformance: A higher Information Ratio indicates superior risk-adjusted returns relative to the benchmark, reflecting better consistency and skill.
Tracking Error Sensitivity: The denominator, tracking error, measures the variability of returns compared to the benchmark, highlighting the cost of deviation.
Ideal for Strategy Comparison: Particularly useful for comparing active investment strategies or funds that aim to outperform a benchmark.
Consistency Over Time: A consistently high Information Ratio suggests that the manager or strategy can generate repeatable outperformance.
Focus on Relative Performance: Unlike the Sharpe ratio or Sortino ratio, the Information Ratio emphasizes performance relative to a specific benchmark rather than an absolute risk-free rate.
Portfolio Adjustment Tool: Use the Information Ratio to identify and adjust underperforming strategies or funds in a portfolio.
Impacted by Market Conditions: The ratio is sensitive to market volatility and shifts in the benchmark, requiring periodic reevaluation.
Limitations: A high Information Ratio does not always guarantee absolute returns, as it focuses solely on performance relative to the benchmark.
Supplementary Use: Combine the Information Ratio with absolute return measures to understand both relative and total performance comprehensively.

Conclusion

The Information Ratio is an valuable tool for evaluating the performance of trading strategies and portfolio managers. It not only measures returns but also the consistency of those returns relative to a benchmark, providing a nuanced view of skill versus luck. By understanding and leveraging the Information Ratio, you can make more informed trading decisions, optimize your strategies, and ultimately enhance your investment performance.

Sortino Ratio Treynor Ratio