Incremental information ratio

What Is Incremental Information Ratio?

The Incremental Information Ratio (IIR), commonly known as the Information Ratio (IR), is a risk-adjusted performance measure used in Portfolio Performance Measurement. It quantifies the amount of excess return a portfolio manager generates beyond a chosen benchmark, relative to the volatility of those excess returns, also known as tracking error.⁵⁰, ⁵¹ In essence, the Information Ratio assesses how consistently a manager is able to outperform a benchmark for each unit of additional risk taken.⁴⁸, ⁴⁹ This metric is particularly vital in active management, where the goal is to beat the market, rather than simply replicating its performance.

History and Origin

The concept of the Information Ratio has its roots in the broader field of modern portfolio theory, building upon earlier risk-adjusted performance measures. While direct historical accounts for the "Incremental Information Ratio" as a distinct term are scarce, it refers to the core idea behind the Information Ratio. The Information Ratio itself evolved as a specialized application of risk-adjusted performance analysis, allowing for the evaluation of active management performance against a specific benchmark, moving beyond the traditional comparison to a risk-free rate. Its development aligned with the increasing focus on evaluating the skill of investment managers and the value they add over a passive index. Organizations like the CFA Institute have significantly contributed to standardizing and promoting performance measurement practices, including the use and interpretation of metrics like the Information Ratio.⁴⁶, ⁴⁷

Key Takeaways

• The Incremental Information Ratio (Information Ratio) measures a portfolio's active return relative to its active risk.⁴⁵
• It assesses a manager's ability to consistently generate excess returns against a benchmark.⁴⁴
• A higher Information Ratio indicates better risk-adjusted performance.⁴², ⁴³
• The metric is crucial for evaluating active investment strategies and comparing fund managers.⁴¹
• It helps investors determine if the value added by an actively managed fund justifies its higher fees.

Formula and Calculation

The formula for the Information Ratio (IR) is:

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

Where:

• (R_p) = Portfolio return³⁹, ⁴⁰
• (R_b) = Benchmark return³⁷, ³⁸
• (R_p - R_b) = Excess return (also known as active return)³⁵, ³⁶
• (\sigma_{p-b}) = Standard deviation of the excess returns (also known as active risk or tracking error)³², ³³, ³⁴

This calculation allows for the comparison of how much additional return is achieved for each unit of additional volatility taken relative to the benchmark.³¹

Interpreting the Information Ratio

A higher Information Ratio generally indicates superior risk-adjusted return and a more consistent ability to generate returns above the benchmark.²⁹, ³⁰ For instance, an Information Ratio of 0.5 suggests that for every unit of tracking error, the portfolio generated 0.5 units of excess return. While there's no universally "good" Information Ratio, values of 0.5 or higher are often considered favorable, and values of 1.0 or above are generally considered excellent.²⁷, ²⁸ A negative Information Ratio implies that the portfolio underperformed its benchmark, indicating that the active management strategy did not add value relative to the chosen benchmark.²⁵, ²⁶ When evaluating this metric, it is important to consider the investment strategy and market conditions.²⁴

Hypothetical Example

Consider two hypothetical mutual funds, Fund X and Fund Y, both benchmarked against the S&P 500 index over a year.

• S&P 500 Return (Benchmark): 10%

• Fund X:

  • Portfolio Return: 15%
  • Excess Return ($R_p - R_b$): 15% - 10% = 5%
  • Tracking Error ($\sigma_{p-b}$): 4%
  • Information Ratio (IR): $5% / 4% = 1.25$

• Fund Y:

  • Portfolio Return: 12%
  • Excess Return ($R_p - R_b$): 12% - 10% = 2%
  • Tracking Error ($\sigma_{p-b}$): 1%
  • Information Ratio (IR): $2% / 1% = 2.00$

In this example, Fund X achieved a higher absolute excess return (5% vs. 2%). However, Fund Y has a significantly higher Information Ratio (2.00 vs. 1.25). This suggests that Fund Y's manager delivered more excess return per unit of active risk taken, demonstrating a more efficient investment strategy in terms of risk-adjusted outperformance. This highlights the importance of considering consistency and active risk when evaluating performance, not just raw returns.

Practical Applications

The Information Ratio is a fundamental tool for various stakeholders in the financial industry:

• Manager Selection: Investors, particularly institutional investors and consultants, use the Information Ratio to compare the skill and consistency of different portfolio management teams. It helps identify managers who consistently deliver strong risk-adjusted returns relative to their benchmarks.²², ²³
• Performance Attribution: Within asset management firms, the Information Ratio is used in performance attribution analysis to understand the sources of active returns and assess the effectiveness of specific investment decisions.²¹
• Risk Management: By highlighting the active risk taken, the Information Ratio helps managers and investors ensure that the level of deviation from the benchmark is commensurate with the desired active return.
• Compensation Structures: In some cases, performance-based fees for fund managers may be linked to the Information Ratio, incentivizing them to generate consistent excess returns while managing active risk.²⁰
• Compliance and Reporting: Financial entities are subject to regulatory guidelines regarding performance advertising. For example, the U.S. Securities and Exchange Commission (SEC) has adopted rules governing investment adviser marketing, emphasizing fair and balanced presentation of performance results, which indirectly influences how such metrics are presented.¹⁸, ¹⁹

Limitations and Criticisms

While the Information Ratio is a valuable tool, it has several limitations:

• Backward-Looking: Like many performance metrics, the Information Ratio is based on historical data. Past performance does not guarantee future results, and a high Information Ratio in the past does not predict future outperformance.¹⁶, ¹⁷
• Benchmark Dependency: The calculated Information Ratio is highly sensitive to the choice of benchmark. An inappropriate or poorly chosen benchmark can misrepresent a manager's true skill.¹⁴, ¹⁵
• Volatility as Risk: The Information Ratio uses standard deviation (tracking error) as its measure of active risk. Some critics argue that volatility does not fully capture all aspects of risk, particularly for strategies that might have infrequent but large drawdowns or exhibit non-normal return distributions.¹², ¹³
• Short-Term vs. Long-Term: The Information Ratio can be sensitive to the time period over which it is calculated. Shorter periods may not accurately reflect a manager's long-term consistency, while very long periods can smooth out significant but temporary performance deviations.¹¹
• Lack of Predictive Power: It does not account for external factors such as changes in market conditions or regulatory shifts that can significantly influence a manager's ability to generate alpha.¹⁰

Incremental Information Ratio vs. Sharpe Ratio

Both the Incremental Information Ratio (Information Ratio) and the Sharpe Ratio are crucial risk-adjusted performance measures, but they serve different purposes and use different benchmarks. The core distinction lies in what they aim to measure:

The Information Ratio is particularly useful for assessing how well a fund manager's active decisions add value compared to a specific market index. The Sharpe Ratio, conversely, gauges how much return an investor gets for each unit of total risk taken, considering a risk-free investment as the baseline.⁹

FAQs

What does a high Incremental Information Ratio indicate?

A high Incremental Information Ratio, or Information Ratio, indicates that a portfolio manager has consistently generated significant returns above their benchmark, relative to the additional risk taken to achieve those returns. It suggests strong skill and efficiency in active management.⁷, ⁸

Can the Incremental Information Ratio be negative?

Yes, the Information Ratio can be negative. A negative Information Ratio signifies that the portfolio's return was less than the benchmark's return, meaning the active management strategy underperformed and did not generate positive excess returns.⁵, ⁶

Is the Information Ratio used for passive investments?

The Information Ratio is primarily designed for evaluating active management strategies.⁴ For passive investments, like index funds or Exchange-Traded Funds (ETFs), which aim to replicate a benchmark's performance, the Information Ratio would ideally be close to zero, as there is little to no active return or active risk by design.², ³

How does Information Ratio help in portfolio construction?

While not directly a portfolio construction tool like Diversification models or the Capital Asset Pricing Model (CAPM), the Information Ratio helps in selecting skilled active managers for inclusion in a portfolio. By identifying managers who consistently deliver risk-adjusted alpha, investors can strategically allocate capital to enhance overall portfolio performance.¹

What is a good time horizon for calculating the Information Ratio?

To ensure the Information Ratio provides meaningful insights into a manager's abilities and consistency, it is generally recommended to look at performance over at least three to five years, and ideally longer. This helps to smooth out short-term market fluctuations and provides a more reliable assessment of sustained performance.

External Links

• SEC Marketing Rule: 17 CFR § 275.206(4)-1 - Investment adviser marketing.
• CFA Institute: Global Investment Performance Standards (GIPS)
• Morningstar: Information Ratio Glossary
• S&P Dow Jones Indices: SPIVA U.S. Scorecard