With this information ratio calculator, you can easily analyze your portfolio's excess return against the tracking error. The information ratio is one of the most commonly used metrics to measure the portfolio manager's skill in managing investments.
We have prepared this article to help you understand what information ratio is and how to calculate it using the information ratio formula. We will also demonstrate some information ratio examples to better help you to understand the concept. Now, let's start by discussing the fundamentals.
What is the information ratio (IR)?
Unlike the Sharpe ratio, which compares the portfolio return against the risk-free return, the information ratio is commonly used to analyze a portfolio manager's ability to generate excess return against the benchmark return.
Now, let's dive into the calculation using the information ratio formula.
How to calculate information ratio?
Let's have a look at Company Alpha as the information ratio calculation example. It reports the following data, which we can use to talk about how we should use the information ratio formula:
- Beginning portfolio value: $2,000,000
- Ending portfolio value: $2,200,000
- Benchmark return: 8%
- Tracking error: 5%
- Determine your portfolio return
The first step is to calculate the
portfolio returnusing the formula below:
portfolio return = (ending portfolio value - beginning portfolio value) / beginning portfolio value
portfolio returnof Company Alpha is:
($2,200,000 - $2,000,000) / $2,000,000 = 10%.
- Determine the benchmark return
A benchmark is an index that represents the investment the portfolio invests in. If you invest in the US stock market, the appropriate index will be the S&P 500.
For our example, we will assume the
benchmark returnto be
8%since the average annual return of S&P 500 is usually between 8% and 10%.
- Determine the tracking error
tracking erroris defined as the standard deviation of the difference between portfolio returns and benchmark returns. In our example, the
- Calculate the information ratio
information ratiocan be calculated using the following equation:
information ratio = (portfolio return - benchmark return) / tracking error
information ratiofor Company Alpha's portfolio is:
(10% - 8%) / 5% = 0.4.
You can solve all of these tedious computations in no time using our information ratio calculator.
Information ratio vs Sharpe ratio
Information ratio and Sharpe ratio are often used together as their usages are very similar - they both measure portfolio return in a risk-adjusted way and compare it against a risk measure.
The Sharpe ratio compares the portfolio returns to the risk-free rate and measures it against the standard deviation of the portfolio returns. Instead of the risk-free rate, the information ratio, which you can estimate with our information ratio calculator, measures the portfolio returns against its benchmark. Since the information ratio uses a benchmark as a guideline, the excess return is measured against the tracking error instead of the standard deviation of the portfolio.
We use the Sharpe ratio more commonly as it gives us the return we can generate on top of the risk-free return. However, for investors, the information ratio can provide extra insight. Since the metric measures portfolio returns against the benchmark return, it tells the investors if the investments outperforms the benchmark. For example, if the investment could not outperform the passive index such as S&P 500, the investors might be better off just putting their money into the S&P 500.
What is a benchmark?
A benchmark is an appropriate index to compare your investment against. For instance, if you are investing in the US stock market, the S&P 500 would be your benchmark. If you are investing in the UK stock market, the standard benchmark is the FTSE 100.
What is Sharpe ratio?
Sharpe ratio is a widely used metric to compare the portfolio return to the risk-free return, which is then divided by the standard deviation of portfolio return. It measures the amount of extra return you can get by taking on a unit of risk.
What is excess return?
The excess return is defined as the difference between the portfolio return and the benchmark return. A positive excess return indicates that the portfolio manager has the skills to outperform the benchmark, whereas a negative excess return indicates that the return of the portfolio is less than the benchmark.
Can information ratio be negative?
The short answer is yes. The information ratio can be negative. This happens when the portfolio return is lower than the benchmark return, creating a negative excess return. A negative information ratio indicates a lack of skills of the portfolio manager as they are unable to generate superior returns than the benchmark.