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An information ratio is a calculation that has to do with the amount of return realized by an investment portfolio that is above a specified benchmark, with allowances made for the volatility associated with those returns. Information ratios are often considered a helpful strategy in assessing the effectiveness of a manager’s ability to consistently generate a return on the investments that compose the portfolio. The ratio may be calculated to cover a period as short as a month, or as long as a couple of years, with the calculation adjusted to allow for annualization of the data used to determine the ratio for the period under consideration.
Establishing the benchmark that is used to evaluate the amount of return is crucial to determining the information ratio. Many approaches call for using an index that is relevant to the market where the securities included in the portfolio are traded. Allowances for what is known as the tracking error must also be made. The tracking error is simply the deviation that exists between the index returns and the portfolio returns. This combination of assessing the returns and the related tracking error makes it possible to identify the real consistency of the manager’s efforts, since it is possible to have a higher tracking error that offsets the returns and results in a lower information ratio.
It is also possible to make use of this ratio when assessing the effectiveness of administrators of hedge or mutual funds. Here, the formula involves identifying the anticipated return on the portfolio and dividing it by the amount of risk that the administrator assumes, and then relating that data to the benchmark that is identified. A higher ratio indicates that the manager or administrator is meeting the expectations of the investors in the fund, and is making use of investment strategies that are in the best interests of the fund. In the event that the information ratio indicates the administrator is not consistently moving the fund forward, steps to correct the situation can be taken, thus protecting the interests of all investors involved with the fund.
While many investors and others in the financial community consider the basic information ratio formula to be an effective tool in assessing the management of a portfolio, there are those who feel the data derived from the effort is limited in what it tells about the performance of the manager. For example, while the usual mode of calculating the ratio does rely on sound mathematical processes, it does not allow for the consideration of leverage, a factor that can and often does impact how efficiently a portfolio is being managed. For this reason, some experts recommend the use of formulas that do allow for the impact of leverage as a means of obtaining a more well-rounded assessment of the consistency of the manager.