Economic information ratio

What Is Economic Information Ratio?

The Economic Information Ratio is a measure in portfolio theory that quantifies the active return of a portfolio per unit of tracking error. It assesses the consistency of a portfolio manager's ability to generate returns above a specific benchmark, relative to the volatility of those excess returns. Essentially, the Economic Information Ratio indicates how much "bang for the buck" an investor receives in terms of active return for the active risk taken. This metric is a key component in evaluating the effectiveness of active management strategies.

History and Origin

While the concepts underpinning the Economic Information Ratio have roots in earlier ideas of risk and return, its formalization and widespread adoption in the investment community are largely attributed to the work of Richard Grinold and Ronald Kahn. Their seminal work, Active Portfolio Management, published in 1995, extensively developed the framework for evaluating active strategies, including the Economic Information Ratio and the "Fundamental Law of Active Management." This law posits that a manager's ability to generate a high Economic Information Ratio is a function of their skill (information coefficient) and the number of independent investment decisions they make (breadth).⁵

Further clarification and discussion of the Economic Information Ratio's calculation and interpretation were provided in academic literature, notably by Thomas H. Goodwin in his 1998 article "The Information Ratio" published in the Financial Analysts Journal. Goodwin's work helped to demystify some of the complexities surrounding its practical application and interpretation in the industry.³, ⁴

Key Takeaways

• The Economic Information Ratio measures the active return of a portfolio relative to its tracking error.
• It is a critical metric for evaluating the skill and consistency of active portfolio managers.
• A higher Economic Information Ratio indicates more efficient active management, providing greater active return for a given level of active risk.
• The ratio helps investors compare the value added by different investment strategies against a specific benchmark.
• The concept is foundational to the "Fundamental Law of Active Management," linking manager skill and investment breadth to the Economic Information Ratio.

Formula and Calculation

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

Active Return is the difference between the portfolio's return ($R_p$) and the benchmark's return ($R_b$).
Tracking Error is the standard deviation of these active returns.

The formula is expressed as:

$IR = \frac{R_p - R_b}{\sigma_{p-b}}$

Where:

• $R_p$: Portfolio's return
• $R_b$: Benchmark's return
• $\sigma_{p-b}$: Standard deviation of the active returns (tracking error)

The active return is often referred to as alpha, particularly when the benchmark is the market portfolio as defined in models like the Capital Asset Pricing Model. The tracking error measures the volatility of the portfolio's performance relative to its benchmark, indicating the active risk taken.

Interpreting the Economic Information Ratio

Interpreting the Economic Information Ratio involves understanding that a higher ratio generally signifies superior risk-adjusted return generated by an active manager. An Economic Information Ratio of 0.50 or higher is often considered good, while a ratio of 0.75 or 1.00 can indicate exceptional performance. However, what constitutes a "good" Economic Information Ratio can vary depending on the asset class, investment style, and market conditions.

For example, a fixed-income manager might have a consistently high Economic Information Ratio with lower absolute active returns and tracking errors compared to an equity manager, due to the inherent differences in volatility between these asset classes. Investors use this ratio to determine if the active risk undertaken by a portfolio manager is adequately compensated by the generated excess returns, providing a more comprehensive view of portfolio performance than simply looking at total returns.

Hypothetical Example

Consider two hypothetical investment funds, Fund A and Fund B, both benchmarked against the S&P 500.

Fund A:

• Annualized Portfolio Return: 12%
• S&P 500 Benchmark Return: 10%
• Tracking Error (Standard Deviation of Active Returns): 3%

Calculation for Fund A:
Active Return = 12% - 10% = 2%
Economic Information Ratio = $\frac{2%}{3%} = 0.67$

Fund B:

• Annualized Portfolio Return: 15%
• S&P 500 Benchmark Return: 10%
• Tracking Error (Standard Deviation of Active Returns): 8%

Calculation for Fund B:
Active Return = 15% - 10% = 5%
Economic Information Ratio = $\frac{5%}{8%} = 0.625$

In this hypothetical example, while Fund B generated a higher absolute active return (5% vs. 2%), Fund A exhibits a slightly higher Economic Information Ratio (0.67 vs. 0.625). This suggests that Fund A achieved its active return more efficiently, taking less active risk relative to the excess return generated. Investors seeking consistent, lower-volatility outperformance might prefer Fund A, even with its lower active return, due to its better Economic Information Ratio and potentially more effective investment strategy.

Practical Applications

The Economic Information Ratio is widely used in various facets of the financial industry. Its primary application is in the evaluation of active investment managers, providing a standardized metric to compare their skill in generating returns above a benchmark while considering the associated active risk. Institutional investors, consultants, and fund selectors frequently employ the Economic Information Ratio when conducting due diligence on potential managers or monitoring existing mandates.

It is also used by managers internally for self-assessment and strategy refinement. For instance, a firm might use the Economic Information Ratio to analyze different sub-portfolios or trading strategies within a larger fund to identify areas of strength or weakness. Furthermore, the ratio can inform capital allocation decisions within a multi-manager framework, helping to allocate capital to managers with higher, more consistent Economic Information Ratios.

When presenting performance, investment advisers must comply with regulations such as the U.S. Securities and Exchange Commission (SEC) Marketing Rule. This rule requires that any presentation of gross performance must be accompanied by net performance with at least equal prominence, ensuring that investors understand the impact of fees and expenses.² The Economic Information Ratio, as a risk-adjusted metric, typically uses net returns for accurate assessment of what an investor truly receives.

Limitations and Criticisms

Despite its utility, the Economic Information Ratio has limitations. One common criticism centers on its reliance on the chosen benchmark. If the benchmark is not appropriate for the portfolio's investment strategy, the Economic Information Ratio may provide a misleading assessment of a manager's skill. For instance, a manager specializing in small-cap stocks might show a poor Economic Information Ratio if benchmarked against a large-cap index, simply due to the mismatch.

Another limitation arises from the potential for the ratio to be manipulated or appear higher due to an extremely low tracking error, even if the active return is also small. Conversely, a highly skilled manager taking concentrated bets might have a higher tracking error, which could depress their Economic Information Ratio, even if their active return is substantial. Furthermore, the Economic Information Ratio does not account for non-normal distributions of returns, and extreme events or "fat tails" in performance data can significantly skew the ratio. Academic discussions continue to explore these nuances, aiming to provide a comprehensive understanding of its applicability and pitfalls.¹ Investors considering active strategies should look at the Economic Information Ratio in conjunction with other metrics and qualitative factors, such as the manager's investment process, philosophy, and diversification practices.

Economic Information Ratio vs. Sharpe Ratio

The Economic Information Ratio and the Sharpe Ratio are both widely used risk-adjusted return measures in finance, but they serve different purposes and use different benchmarks.

While the Economic Information Ratio gauges a manager's ability to add value beyond a specific market or peer group, the Sharpe Ratio assesses the absolute performance of a portfolio by comparing its excess return over the risk-free rate to its total volatility. Both are important tools in analyzing portfolio performance, but the Economic Information Ratio is more relevant when evaluating a manager's active bets and their success in deviating from a chosen reference, whereas the Sharpe Ratio is more generally applicable for assessing the overall efficiency of any investment. The Modern Portfolio Theory provides the theoretical underpinning for both measures.

FAQs

What is a "good" Economic Information Ratio?

While there's no universally agreed-upon threshold, an Economic Information Ratio of 0.50 or higher is generally considered good, indicating that a portfolio manager is generating meaningful active returns relative to the active risk taken. Exceptional managers might achieve ratios of 0.75 or 1.00. However, what is considered "good" can vary significantly based on the asset class, investment style, and prevailing market conditions.

Can the Economic Information Ratio be negative?

Yes, the Economic Information Ratio can be negative if a portfolio's active return is negative, meaning the portfolio underperformed its benchmark. A negative Economic Information Ratio indicates that the active bets taken by the manager detracted from performance.

How does the Economic Information Ratio relate to manager skill?

The Economic Information Ratio is considered a strong indicator of a manager's skill. According to the "Fundamental Law of Active Management," a higher Economic Information Ratio is achieved through a combination of a manager's forecasting ability (information coefficient) and the number of independent investment decisions they make (breadth). It quantifies the consistency of their ability to generate residual return.

Is the Economic Information Ratio annualized?

Yes, the Economic Information Ratio is typically annualized for comparison purposes. Both the active return and the tracking error (standard deviation of active returns) are annualized before calculating the ratio. This allows for consistent evaluation of performance over different time horizons.