Information ratio is a financial metric that measures the return on an investment relative to its risk. It is calculated by dividing the excess return of an investment over a benchmark by the standard deviation of the excess return. The information ratio is a useful tool for investors to evaluate the performance of their investments and to compare different investments. It can also be used to identify investments that are undervalued or overvalued.
Information Ratio: A Comprehensive Guide
The information ratio measures the excess return of an investment portfolio over a benchmark, while adjusting for the volatility of the excess return. It is a valuable metric for evaluating the performance of a portfolio manager.
Calculation
The information ratio is calculated as:
- Excess Return: Return of the portfolio minus return of the benchmark
- Volatility: Standard deviation of the excess return
Interpretation
- Positive Information Ratio: The portfolio manager is generating excess return in excess of the risk taken (outperforming the benchmark)
- Negative Information Ratio: The portfolio manager is not generating sufficient excess return relative to the risk taken (underperforming the benchmark)
- High Information Ratio: Indicates a portfolio manager who consistently generates excess return with relatively low volatility
- Low Information Ratio: Indicates a portfolio manager who struggles to generate excess return or takes on excessive risk
Structure of an Information Ratio Table
| Metric | Value |
|---|---|
| Portfolio Return | 10% |
| Benchmark Return | 8% |
| Excess Return | 2% |
| Volatility of Excess Return | 4% |
| Information Ratio | 0.5 |
Factors Affecting Information Ratio
- Portfolio Management Style: The volatility and correlation of the portfolio’s assets can impact the information ratio.
- Benchmark Selection: The benchmark should represent a suitable comparison for the portfolio’s objectives.
- Time Horizon: The information ratio may vary over different time periods.
- Survivorship Bias: Funds with poor performance may not be included in the analysis, which can overstate the information ratios of surviving funds.
Limitations
- Assumes Normality: The calculation assumes that the excess returns are normally distributed, which may not always be the case.
- Influenced by Outliers: Extreme returns can distort the information ratio.
- Not a Risk-Adjusted Measure: The information ratio does not adjust for the overall risk profile of the portfolio.
Question 1:
What is the definition of information ratio?
Answer:
Information ratio is a statistical measure that quantifies the excess return of an investment portfolio over a benchmark, adjusted for the portfolio’s volatility.
Question 2:
How is information ratio calculated?
Answer:
Information ratio is calculated by dividing the portfolio’s excess return by its annualized standard deviation. Excess return is the difference between the portfolio’s return and the benchmark’s return.
Question 3:
What does a high information ratio indicate?
Answer:
A high information ratio (greater than 1) indicates that the portfolio has consistently outperformed its benchmark, on a risk-adjusted basis. This suggests that the portfolio manager has skill in selecting and managing investments.
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