What is Information Ratio (IR) and how is it calculated?
How is Information Ratio (IR) different from Sharpe Ratio and what does it measure?
The Information Ratio (IR) is the Sharpe Ratio of excess daily return. It is used by investors to evaluate the performance of an investment strategy or portfolio. The excess daily return is the return of the investment strategy or portfolio minus the return of a benchmark or a risk-free rate.
Understanding Information Ratio (IR)
Information Ratio (IR) is a measure that assesses the risk-adjusted return of an investment strategy or portfolio by comparing it to a benchmark. It is calculated by taking the excess daily return (the return of the strategy minus the return of the benchmark) and dividing it by the tracking error (the standard deviation of the excess return).
Comparison with Sharpe Ratio
Sharpe Ratio is another commonly used measure of risk-adjusted return. While the Sharpe Ratio looks at the excess return relative to the total risk of the investment (as measured by the standard deviation of return), the Information Ratio focuses on the excess return relative to the benchmark.
What does Information Ratio Measure?
The Information Ratio helps investors understand whether the excess return generated by an investment strategy is due to skill or simply taking on higher levels of risk. A higher Information Ratio indicates that the strategy has outperformed the benchmark on a risk-adjusted basis, suggesting that the manager has skill in generating returns.
Calculation of Information Ratio
To calculate the Information Ratio, you first need to determine the excess daily return of the investment strategy compared to the benchmark. This can be done by subtracting the benchmark return from the strategy return on a daily basis. Then, you calculate the tracking error, which is the standard deviation of the excess returns over a specific period of time. Finally, divide the excess return by the tracking error to get the Information Ratio.
Investors use the Information Ratio to assess the consistency and skill of a portfolio manager in generating excess returns above the benchmark. A positive Information Ratio indicates that the manager has added value through active management, while a negative Information Ratio suggests underperformance compared to the benchmark.
Overall, Information Ratio provides valuable insights into the performance of an investment strategy and helps investors make more informed decisions when evaluating portfolio managers or investment opportunities.