Adjusted information ratio

What Is Adjusted Information Ratio?

The Adjusted Information Ratio is a refined metric within portfolio theory used to evaluate the skill and consistency of an active portfolio manager. It builds upon the traditional Information Ratio by accounting for additional factors that can influence a portfolio's risk-adjusted returns. These adjustments often include considerations like transaction costs, liquidity, and the volatility of a manager's investment insights. The primary goal of calculating an Adjusted Information Ratio is to provide a more realistic and comprehensive assessment of a manager's ability to generate alpha relative to a benchmark, net of practical constraints and real-world frictions inherent in active management.

History and Origin

The concept of the Information Ratio (IR) itself emerged from modern portfolio management as a key measure for evaluating active strategies. It quantifies the excess return generated by a portfolio relative to its benchmark, divided by the tracking error of that excess return. The theoretical foundation for understanding the drivers of the Information Ratio lies in the Fundamental Law of Active Management, which posits that a manager's expected IR is a function of their information coefficient (skill) and investment breadth (number of independent bets).⁹

However, as the application of the IR became widespread, practitioners and academics recognized that the standard formula did not fully capture certain real-world complexities. Factors such as portfolio turnover, which incurs trading costs, and the dynamic nature of a manager's skill (information coefficient volatility) could significantly impact actual performance but were not directly incorporated into the traditional IR calculation. Research has since sought to extend this relationship by explicitly accounting for the cost from portfolio turnover and the volatility of the information coefficient, leading to the development of an "Adjusted Information Ratio" concept to provide a more complete picture of a manager's true contribution.⁸

Key Takeaways

• The Adjusted Information Ratio refines the standard Information Ratio by incorporating real-world factors like trading costs and investment constraints.
• It provides a more accurate measure of a portfolio manager's skill in generating consistent excess returns.
• Adjustments help to differentiate between true alpha generation and returns influenced by uncompensated risks or operational frictions.
• A higher Adjusted Information Ratio generally indicates superior, more efficient active management.
• It is a crucial tool for sophisticated investors in manager selection and performance attribution.

Formula and Calculation

The specific formula for an Adjusted Information Ratio can vary depending on the factors being adjusted. One common adjustment involves accounting for portfolio turnover and its associated transaction costs. While the exact mathematical representation can be complex, a simplified conceptual adjustment might look like this:

More formally, an adjustment for turnover, as discussed in academic literature, implies that a turnover-adjusted IR would generally be lower than an IR that ignores these costs.⁷ The numerator (excess return) could be reduced by the costs associated with achieving those returns.

The traditional Information Ratio ((\text{IR})) is calculated as:

Where:

• (E(R_P - R_B)) represents the expected alpha, or the expected excess return of the portfolio ((R_P)) over the benchmark ((R_B)).
• (\sigma(R_P - R_B)) represents the tracking error, which is the standard deviation of the portfolio's excess returns.

An Adjusted Information Ratio incorporates further deductions or modifications to the numerator or potentially adjustments to the denominator to reflect a more accurate portrayal of the manager's net performance, considering factors like explicit trading costs or the implicit cost of a volatile information coefficient.

Interpreting the Adjusted Information Ratio

Interpreting the Adjusted Information Ratio requires understanding that it seeks to present a "cleaner" view of a manager's performance by stripping out or accounting for elements that might distort the raw Information Ratio. A higher Adjusted Information Ratio suggests that the manager is not only generating alpha but is doing so efficiently, perhaps by limiting unnecessary trading or by having very consistent insights. It is a measure of the net skill of the active manager.

For example, two managers might have similar raw Information Ratios. However, if one manager consistently generates high turnover that leads to significant transaction costs, their Adjusted Information Ratio, which accounts for these costs, would likely be lower than the manager who achieves similar returns with less trading activity. This provides a more nuanced evaluation of their ability to deliver net value. It also helps investors gauge the effectiveness of a manager's investment policy and execution.

Hypothetical Example

Consider two hypothetical active managers, Fund A and Fund B, both managing equity portfolios with the S&P 500 as their benchmark.

Over the past three years:

• Fund A:

  • Average Annual Excess Return: 3.0%
  • Tracking Error: 5.0%
  • Transaction Costs (annualized as a drag on return): 0.5%
  • Raw Information Ratio (3.0% / 5.0%) = 0.60
  • Adjusted Information Ratio = (\frac{3.0% - 0.5%}{5.0%} = \frac{2.5%}{5.0%} = 0.50)

• Fund B:

  • Average Annual Excess Return: 3.2%
  • Tracking Error: 5.5%
  • Transaction Costs (annualized as a drag on return): 0.2%
  • Raw Information Ratio (3.2% / 5.5%) (\approx) 0.58
  • Adjusted Information Ratio = (\frac{3.2% - 0.2%}{5.5%} = \frac{3.0%}{5.5%} \approx 0.55)

In this scenario, Fund A initially appears to have a slightly better raw Information Ratio (0.60 vs. 0.58). However, after adjusting for transaction costs, Fund B's Adjusted Information Ratio (0.55) is superior to Fund A's (0.50). This indicates that while Fund A generated a slightly higher gross excess return for the risk taken, its higher operational costs eroded more of that advantage, making Fund B the more efficient performer on an adjusted basis. This deeper dive is critical for truly understanding risk-adjusted returns.

Practical Applications

The Adjusted Information Ratio is primarily used in sophisticated investment analysis and portfolio management contexts. Its applications include:

• Manager Selection: Institutional investors and wealth managers use the Adjusted Information Ratio to rigorously compare and select active managers. It helps them identify managers who deliver true value, beyond what might be obscured by trading activity or other frictions.
• Performance Evaluation: It provides a more comprehensive tool for evaluating the ongoing performance of an active management strategy against its stated objectives and its benchmark, offering insights into the consistency and quality of decision-making.
• Compensation Structures: Some performance-based compensation schemes for fund managers may incorporate adjusted metrics, aligning incentives with net-of-cost value creation.
• Strategy Refinement: For asset managers themselves, analyzing an Adjusted Information Ratio can highlight areas where operational efficiency can be improved, such as optimizing trading strategies to reduce excessive transaction costs. Academic research emphasizes that managers may even improve their investment performance or Information Ratio by limiting or optimizing portfolio turnover.⁶
• Risk Management: By providing a clearer picture of returns relative to active risk, an Adjusted Information Ratio aids in better understanding the effectiveness of a strategy given its risk budget.

Limitations and Criticisms

While the Adjusted Information Ratio offers a more refined view of performance, it still shares some of the inherent limitations of its traditional counterpart, and introduces its own complexities.

• Subjectivity of Adjustments: The specific adjustments made can be subjective. Deciding which costs to include (e.g., explicit trading costs, bid-ask spreads, market impact) and how to quantify them consistently can be challenging. The method of adjustment can significantly influence the resulting Adjusted Information Ratio.
• Data Intensive: Calculating an Adjusted Information Ratio, especially one that accounts for granular factors like transaction costs or the volatility of the information coefficient, requires detailed and accurate data, which may not always be readily available or easily parsed.
• Reliance on Historical Data: Like the standard Information Ratio, the adjusted version is backward-looking. While it provides insights into past performance, it does not guarantee future results. Changes in market conditions, economic environments, or investment styles can impact its predictive power.⁵
• Benchmark Dependency: The choice of benchmark remains critical. An inappropriate benchmark can distort the meaning of the ratio, even after adjustments. Small differences in benchmark composition can lead to large differences in Information Ratios.⁴
• Normal Distribution Assumption: The underlying assumption that excess returns are normally distributed can be a limitation. Real-world returns often exhibit skewness and kurtosis, and the ratio may not fully capture downside risk or tail risks.³ Critics argue that the Information Ratio can be sensitive to the choice of benchmark and may not adequately capture tail risks or extreme events.²

Adjusted Information Ratio vs. Information Ratio

The distinction between the Adjusted Information Ratio and the traditional Information Ratio lies in the level of detail and realism incorporated into the performance assessment.

The Adjusted Information Ratio attempts to bridge the gap between theoretical performance measurement and the realities of active portfolio management, providing a more robust and actionable metric for discerning true manager skill.¹

FAQs

What does a "good" Adjusted Information Ratio look like?

Similar to the traditional Information Ratio, a higher Adjusted Information Ratio is generally considered better. While there isn't a universally agreed-upon threshold, an Adjusted Information Ratio of 0.5 or higher is often viewed as good, and 1.0 or above is considered excellent, indicating a strong ability to generate consistent alpha while efficiently managing associated costs and risks.

Why is it important to adjust the Information Ratio?

Adjusting the Information Ratio provides a more accurate and realistic assessment of a portfolio manager's performance. By factoring in elements like transaction costs or other operational frictions, it helps distinguish between gross returns and the actual net value added by the manager. This is crucial for investors making informed decisions about fund selection and for managers seeking to optimize their active management strategies.

Can the Adjusted Information Ratio be negative?

Yes, the Adjusted Information Ratio can be negative. If a portfolio's excess returns (after accounting for adjustments) are consistently negative relative to its benchmark, or if the costs and frictions outweigh any positive alpha generated, the Adjusted Information Ratio will be negative, indicating underperformance on an adjusted basis.

How does market volatility affect the Adjusted Information Ratio?

Market conditions and volatility can significantly impact the Adjusted Information Ratio. Higher market volatility can lead to higher tracking error, potentially lowering the ratio if the manager's excess returns don't increase proportionally. Additionally, increased volatility might influence trading costs or the consistency of a manager's insights, which are factors that an Adjusted Information Ratio aims to capture.