Deferred information ratio

Deferred Information Ratio

The term "Deferred Information Ratio" is not a standard or widely recognized financial metric within traditional portfolio theory or performance measurement. It appears to be a conflation of two distinct financial concepts: the Information Ratio, which is a key measure in active management, and the accounting principle of deferral. This article will primarily focus on the established Information Ratio and briefly touch upon the concept of deferral in accounting to clarify why the combined term lacks a standard definition.

What Is the Information Ratio?

The Information Ratio (IR) is a crucial metric in the field of portfolio theory and performance measurement. It quantifies the skill of a portfolio manager by measuring the consistency of their active returns relative to a chosen benchmark, adjusted for the tracking error (active risk). Essentially, it assesses how much excess return an investment manager generates per unit of additional risk taken relative to that benchmark. A higher Information Ratio generally indicates superior risk-adjusted return and more consistent outperformance.³⁰

History and Origin

The Information Ratio has its roots in the broader development of modern portfolio theory. While concepts of risk-adjusted performance existed earlier, the modern formulation of the Information Ratio is widely attributed to Thomas H. Goodwin, who coined the term in his 1998 paper, "The Information Ratio." This built upon earlier work by financial economists such as Jack Treynor and Fischer Black in 1973, who introduced a similar concept known as the "appraisal ratio."²⁸, ²⁹ Further popularization and application within the investment management industry came through the work of Richard Grinold and Ronald Kahn, particularly in their influential 1995 book, Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk. Their "Fundamental Law of Active Management" posits that a manager's Information Ratio is a function of their skill (information coefficient) and the number of independent investment decisions they make (breadth).²⁶, ²⁷ Investment research firms like Research Affiliates continue to contribute to the understanding and application of these principles in active portfolio management.²⁵

Key Takeaways

• The Information Ratio measures a portfolio manager's ability to generate consistent excess returns relative to a benchmark.
• It helps determine if an active management strategy is delivering value proportional to the active risk undertaken.
• A higher Information Ratio indicates better risk-adjusted performance, distinguishing skilled managers from those who benefit from short-term luck.
• The metric is widely used by institutional investors to evaluate and compare different investment strategies.
• It is backward-looking and its effectiveness depends on the appropriateness of the chosen benchmark.

Formula and Calculation

The Information Ratio (IR) is calculated as the expected active return divided by the tracking error.

The formula is:

Where:

• (E(R_p - R_b)) = Expected active return (the expected difference between the portfolio return (R_p) and the benchmark return (R_b)).
• (\sigma_{p-b}) = Tracking error (the standard deviation of the active returns, i.e., the volatility of the difference between the portfolio and benchmark returns).

For historical data, this translates to the average active return divided by the standard deviation of those active returns.²⁴

Interpreting the Information Ratio

A positive Information Ratio suggests that a portfolio has, on average, outperformed its benchmark. The magnitude of the ratio indicates the consistency and efficiency of this outperformance relative to the active risk taken. Generally, a higher Information Ratio is considered better. While specific thresholds can vary, an IR of 0.5 is often considered "good," 0.75 "very good," and 1.0 or higher "exceptional," indicating a manager's strong ability to generate returns above the benchmark with consistency.²², ²³

However, interpretation should always be done in context. An Information Ratio needs to be evaluated over a sufficiently long period (typically at least three to five years) to provide a reliable assessment of a manager's investment performance, as short-term fluctuations can skew results.²¹ It is particularly useful for comparing managers with similar investment styles and objectives against the same benchmark.²⁰

Hypothetical Example

Consider an actively managed equity fund, Fund A, and its benchmark, the S&P 500. Over a five-year period, Fund A generates an average annual return of 10.5%, while the S&P 500 returns 8.5%. The average annual active return is therefore 2.0% (10.5% - 8.5%). The standard deviation of these annual active returns (tracking error) for Fund A is 3.0%.

Using the formula:

In this hypothetical example, Fund A has an Information Ratio of 0.67. This indicates that for every unit of active risk taken relative to the S&P 500, the fund generated 0.67 units of excess return. This value would generally be considered very good, suggesting that the manager of Fund A has demonstrated skill in consistently outperforming the benchmark without taking disproportionate risk. If another Fund B had an IR of 0.40 with the same active return, it would imply Fund B took more active risk for the same excess return, making Fund A more efficient.

Practical Applications

The Information Ratio is a fundamental tool for various participants in the financial markets:

• Fund Selection and Due Diligence: Institutional investors and wealth managers extensively use the Information Ratio to evaluate and select mutual funds, hedge funds, and other actively managed vehicles. It helps them identify managers who consistently add value beyond their benchmark, justifying any higher fees associated with active management.¹⁸, ¹⁹
• Performance Attribution: It aids in understanding whether a portfolio's outperformance is due to genuine managerial skill or merely random fluctuations. By standardizing the excess return by the active risk, the IR offers a clearer picture of skill.
• Setting Investment Mandates: Asset owners often incorporate target Information Ratios into mandates for their external portfolio managers, alongside limits on tracking error, to ensure that managers are aligned with risk-adjusted return objectives.
• Regulatory Compliance: The Securities and Exchange Commission (SEC) provides guidance on how investment advisers must present performance information in marketing materials. While the Information Ratio itself isn't directly regulated regarding its calculation, the underlying performance data and how it is presented, including gross and net returns, falls under the SEC's Marketing Rule (Rule 206(4)-1).¹⁷ Recent updates, such as those issued by the SEC staff in March 2025, clarify requirements for presenting portfolio characteristics like the Information Ratio.¹⁵, ¹⁶

Limitations and Criticisms

Despite its widespread use, the Information Ratio has several limitations:

• Backward-Looking: The IR is calculated using historical data and, like many financial ratios, past performance is not indicative of future results.¹⁴ A manager's high IR in one period does not guarantee future outperformance.
• Benchmark Dependency: The value of the Information Ratio is highly sensitive to the choice of benchmark. An inappropriate or poorly chosen benchmark can lead to misleading conclusions about a manager's skill.¹², ¹³ For instance, evaluating a specialized technology fund against a broad market index like the S&P 500 might inflate the IR if the tech sector significantly outperforms the broader market.
• Assumes Normal Distribution: The calculation of tracking error assumes that the active returns are normally distributed. In reality, market returns, especially during extreme events or "tail risks," often exhibit non-normal distributions, which can affect the reliability of the IR.¹¹
• Does Not Account for All Costs: The standard Information Ratio calculation typically does not explicitly account for transaction costs, taxes, or other real-world expenses, which can impact the net active return achieved by investors.
• Potential for Gaming: Managers might be incentivized to "hug the benchmark" to keep tracking error low, even if it means sacrificing potential high active returns. This can lead to less active, or "closet indexing," strategies.⁹, ¹⁰

Thomas H. Goodwin, in his 1998 paper, challenged the assertion by Grinold and Kahn that consistently high IRs (0.5 to 1.0) are common, finding that sustaining such levels over long periods is more challenging than suggested.⁸

Deferred Information Ratio vs. Information Ratio

As established, "Deferred Information Ratio" is not a recognized financial term. The confusion likely arises from the accounting concept of deferral, which involves postponing the recognition of certain revenues or expenses to future accounting periods.

In accounting, a deferral ensures that financial transactions align with the revenue recognition principle and the matching principle. For example, if a company receives upfront payment for an annual software subscription, the revenue is "deferred" and recognized incrementally over the subscription period, impacting the income statement and balance sheet.⁶, ⁷

The Information Ratio, on the other hand, is a performance measurement metric derived from investment returns and their volatility. It does not directly incorporate accounting deferrals in its standard calculation. If one were to conceptually consider a "Deferred Information Ratio," it might imply a scenario where the portfolio returns or benchmark returns used in the IR calculation are adjusted based on deferred accounting principles. However, this would deviate from the standard practice of using market-based, realized returns for performance evaluation, as accounting deferrals primarily impact the timing of revenue and expense recognition on financial statements rather than actual cash returns or market value changes of investments. Therefore, any attempt to combine "deferred" with "Information Ratio" would require a clear and non-standard definition of how such deferrals would apply to the return series or risk measures.

FAQs

What does a "good" Information Ratio indicate?

A "good" Information Ratio generally indicates that a portfolio manager has consistently generated returns higher than their benchmark, relative to the active risk they took to achieve those returns. Values above 0.5 are often considered favorable, with higher numbers indicating greater skill and consistency.⁵

How does the Information Ratio differ from the Sharpe Ratio?

Both the Information Ratio and the Sharpe Ratio are measures of risk-adjusted return, but they use different benchmarks for comparison. The Sharpe Ratio measures the excess return of a portfolio over a risk-free rate (e.g., U.S. Treasury bills) per unit of total portfolio risk (standard deviation). In contrast, the Information Ratio measures the excess return of a portfolio over a specific market benchmark (e.g., S&P 500) per unit of active risk (tracking error).⁴

Can the Information Ratio be negative?

Yes, the Information Ratio can be negative if a portfolio underperforms its chosen benchmark. A negative IR indicates that the active manager failed to generate excess returns or that their active risk did not lead to positive outperformance.³ This signals underperformance relative to the benchmark.

Why is the choice of benchmark so important for the Information Ratio?

The choice of benchmark is critical because the Information Ratio measures performance relative to it. If the benchmark does not accurately reflect the investment universe or investment objective of the portfolio, the resulting IR can be misleading. An inappropriate benchmark makes the ratio's assessment of manager skill less relevant.¹, ²

Is the Information Ratio used in private equity?

While the core concept of comparing active return to active risk is broadly applicable in finance, traditional Information Ratio calculations are more commonly applied to liquid, publicly traded portfolios where consistent benchmark data and daily price movements allow for straightforward calculation of active returns and tracking error. In private equity, performance measurement often relies on different metrics like Internal Rate of Return (IRR) and Distributed to Paid-in Capital (DPI) due to the illiquid nature of investments and less frequent valuations. However, the underlying principle of assessing value added relative to risk taken remains relevant.