Information ratio

Key Takeaways

  1. The information ratio is a measure of risk adjusted return of a financial security.
  2. It is also known as appraisal ratio.
  3. Information ratio is the risk-adjusted alpha

Information ratio is the ratio comparing the active returns on a portfolio with that on its benchmark index, adjusted against active risk, where active risk is the volatility of the active returns.

Know more

The information ratio is a way to measure the consistency of active returns, as most investors would prefer a consistently generated value (meaning it has a low active risk), rather than a lumpy active returns pattern (with high active risk).

IR is used to measure an active management’s efficiency. A high IR represents a consistently well-performing investment fund.

What does the information ratio tell you?

The information ratio determines the risk-adjusted return of financial security. Appraisal Ratio is another term for information ratio. The information ratio compares the performance of a security with the benchmark index. The active returns mean the value addition on an actively-managed portfolio and are the difference between the returns on the portfolio and the returns on the benchmark portfolio. Many investors use the information ratio to compare various securities to make better investment decisions. The information ratio gives more practical and accurate information than the Sharpe ratio. It gives the results with respect to market volatility.

Information ratio formula

Information ratio is calculated with:-

IR is the information ratio

Rp is the return on the portfolio

Rb is the return on the benchmark

STD(Rp-Rb) is the standard deviation of the difference of returns on the portfolio and on the benchmark, which we call active risk

Information ratio vs. sharpe ratio

While the information ratio compares a security’s performance to the benchmark index, the Sharpe ratio assesses the relative performance of funds or a portfolio manager. The two ratios are nearly identical. The information ratio employs a risky index, whereas the Sharpe ratio uses risk-free return as a benchmark index. This is the only distinction between the two ratios.