Capital information ratio

The Capital Information Ratio, often simply called the Information Ratio (IR), is a key metric within portfolio performance measurement used to evaluate the skill of an investment manager in generating returns above a chosen benchmark while considering the consistency of those returns. It quantifies the amount of excess return an investment manager achieves per unit of tracking error, which represents the volatility of those excess returns. A higher Information Ratio indicates that a manager is consistently outperforming the benchmark with a relatively low level of active risk. The Information Ratio is particularly useful for assessing managers who engage in active management strategies, such as those managing mutual funds or hedge funds.

History and Origin

The concept of evaluating manager performance relative to a benchmark, accounting for risk, has evolved over decades. While rooted in earlier works, the term "Information Ratio" itself gained prominence through the efforts of Thomas H. Goodwin in 1998, who helped popularize its use in the investment community. The theoretical underpinnings are also significantly influenced by the work of Richard Grinold and Ronald Kahn, particularly their contributions to quantitative portfolio management and the "Fundamental Law of Active Management." Their research demonstrated how the Information Ratio could be used to optimize portfolio performance by identifying optimal security combinations that generate the highest excess return relative to a benchmark.⁵

Key Takeaways

• The Information Ratio measures an investment manager's ability to generate returns beyond a benchmark, adjusted for the consistency of those excess returns.
• It is a widely used metric for evaluating the skill and efficiency of active fund managers.
• A higher Information Ratio generally indicates superior risk-adjusted return relative to the chosen benchmark.
• The Information Ratio helps distinguish managers who consistently outperform from those whose outperformance might be due to luck or excessive risk-taking.
• While useful, the Information Ratio should be considered alongside other performance metrics and the specific investment strategy employed.

Formula and Calculation

The Information Ratio (IR) is calculated by dividing a portfolio's active return by its tracking error.

The formula is as follows:

Where:

• (R_p) = Portfolio Return (the total return of the investment portfolio over a specific period)
• (R_b) = Benchmark Return (the total return of the chosen benchmark index over the same period)
• (\sigma_{(R_p - R_b)}) = Tracking Error (the standard deviation of the portfolio's excess returns relative to the benchmark)

The numerator, (R_p - R_b), represents the active return, or the alpha, generated by the manager. The denominator, tracking error, measures the volatility of these active returns, indicating how consistently the portfolio's returns diverge from the benchmark.

Interpreting the Information Ratio

Interpreting the Information Ratio involves understanding that it measures the reward (excess return) per unit of active risk (tracking error). A positive Information Ratio signifies that the manager has generated returns exceeding the benchmark. Conversely, a negative Information Ratio indicates underperformance relative to the benchmark.

Generally, higher Information Ratio values are more desirable. While precise benchmarks for "good" or "excellent" can vary, an Information Ratio above 0.5 is often considered good, and a ratio above 1.0 is generally viewed as excellent, suggesting strong and consistent outperformance relative to the benchmark while taking a moderate level of risk.⁴ It implies that the manager is consistently adding value through their active decisions. When assessing a manager, it is essential to review the Information Ratio over a sufficiently long period, typically at least three years, to gain a more accurate understanding of their abilities and the consistency of their performance.

Hypothetical Example

Consider two hypothetical active fund managers, Manager A and Manager B, both benchmarked against the S&P 500 Index over a five-year period.

• Manager A:

  • Average Annual Portfolio Return ((R_p)): 12%
  • Average Annual Benchmark Return ((R_b)): 10%
  • Tracking Error ((\sigma_{(R_p - R_b)})): 3%

  Calculation for Manager A:
  (IR_A = \frac{12% - 10%}{3%} = \frac{2%}{3%} \approx 0.67)

• Manager B:

  • Average Annual Portfolio Return ((R_p)): 13%
  • Average Annual Benchmark Return ((R_b)): 10%
  • Tracking Error ((\sigma_{(R_p - R_b)})): 5%

  Calculation for Manager B:
  (IR_B = \frac{13% - 10%}{5%} = \frac{3%}{5%} = 0.60)

In this example, Manager A has a slightly higher Information Ratio (0.67) compared to Manager B (0.60). Although Manager B achieved a higher absolute average annual return (13% vs. 12%), Manager A generated their excess return with less relative volatility, as indicated by the lower tracking error (3% vs. 5%). This suggests Manager A delivered more consistent outperformance for the level of active risk taken. This highlights the value of the Information Ratio in assessing performance beyond just raw returns. Investors often seek managers who can achieve consistent outperformance, which contributes positively to overall diversification and portfolio stability.

Practical Applications

The Information Ratio is a fundamental tool in the field of investment management, particularly for those involved in evaluating and selecting active strategies.

• Manager Selection: Asset owners and consultants widely use the Information Ratio to compare the performance of various active investment managers. It helps identify managers who have consistently demonstrated skill in outperforming their chosen benchmarks, rather than simply benefiting from market movements or taking excessive risks. For instance, large institutional investors might use the Information Ratio to vet potential managers for their pension funds or endowments.
• Performance Attribution: It provides insights into the sources of a portfolio's returns. By breaking down performance into benchmark-related returns and active returns, the Information Ratio focuses specifically on the value added (or subtracted) by the manager's security selection and allocation decisions.
• Portfolio Optimization: Investment firms, such as Research Affiliates, often utilize performance metrics and research insights to develop and refine their investment strategies, which can include systematic active equity solutions designed to generate superior risk-adjusted returns.³ The Information Ratio can guide decisions on allocating capital among different active strategies or managers, favoring those with higher and more consistent Information Ratios.
• Risk Management: By emphasizing tracking error, the Information Ratio implicitly encourages managers to manage their active risk relative to the benchmark. It helps ensure that any outperformance is achieved through deliberate skill rather than undue deviations from the benchmark.

Limitations and Criticisms

Despite its widespread use, the Information Ratio is subject to certain limitations and criticisms. One significant potential bias is its sensitivity to the choice of benchmark. A manager might appear skilled simply because an inappropriate or easily beaten benchmark was selected.² If a portfolio deviates significantly from its stated benchmark, the Information Ratio might not fully capture the true risk taken or the nature of the manager's active bets.

Another criticism is that a high Information Ratio does not guarantee future outperformance. Past performance, even when skillful, is not indicative of future results, and market conditions can change, impacting a manager's ability to maintain a high Information Ratio. Some critics also argue that the Information Ratio might incentivize managers to "hug" the benchmark, meaning they stay very close to the benchmark's holdings to keep their tracking error low, potentially limiting true active management and significant alpha generation. This concern suggests that the Information Ratio should be complemented with other measures, such as active share, which quantifies how much a portfolio's holdings differ from its benchmark.

Information Ratio vs. Sharpe Ratio

The Information Ratio and the Sharpe Ratio are both critical measures of risk-adjusted return within portfolio theory, but they serve different purposes and use different benchmarks.

While the Sharpe Ratio evaluates the absolute performance of a portfolio, indicating how much return it generated for each unit of total risk taken above a risk-free asset, the Information Ratio focuses on the manager's ability to add value relative to a specific market or peer group benchmark.¹ Consequently, the Information Ratio is more often used to evaluate active managers, while the Sharpe Ratio is useful for assessing any investment's efficiency, including passive management strategies, on an standalone basis.

FAQs

What is a "good" Information Ratio?

A "good" Information Ratio is generally considered to be above 0.5, while a ratio above 1.0 is often viewed as exceptional. These figures suggest that an investment manager is consistently generating significant excess return for the level of active risk taken relative to their benchmark. However, the interpretation can vary depending on the asset class, market conditions, and investment style.

Why is the Information Ratio important for active managers?

The Information Ratio is crucial for active management because it assesses their ability to outperform a benchmark while controlling active risk. It helps differentiate skilled managers who consistently add value through their investment decisions from those who might achieve sporadic outperformance due to chance or by taking on excessive, unrewarded risks.

How does the Information Ratio relate to tracking error?

The Information Ratio directly incorporates tracking error in its calculation. Tracking error is the denominator of the Information Ratio, measuring the standard deviation of the active returns (the difference between portfolio and benchmark returns). A lower tracking error for a given active return will result in a higher Information Ratio, indicating more consistent outperformance.