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Information Ratio
Information ratio is used to measure the performance of an active fund manager. It is expressed as the active return or alpha (α) of a portfolio divided by the tracking error. Active return or alpha return is the excess return generated by the fund over its benchmark. Tracking error measures the standard deviation of the alpha return.
Information ratio= (R-Rb)/σ= α/ω
Where R= return on the portfolio, Rb= Return on the benchmark σ= Standard deviation of the alpha return, α= alpha of the portfolio and ω= Tracking error
Information ratio is in other words nothing but risk adjusted alpha.
The ratio is similar to the Sharpe ratio, the difference being that instead of using risk free rate, the portfolio return is compared with the benchmark return here. Information ratio is a highly useful tool when one wants to evaluate the performance of an active fund manager. Alpha is the indicator of the stock picking ability of a fund manager. The ratio finds out the incremental return generated by the fund manager for the incremental risk undertaken by the manager to deliver the alpha returns. The higher the active return for the incremental risk undertaken over the benchmark portfolio risk, higher is the stock picking ability of a fund manager. Higher information ratio is therefore associated with superior skills of an active fund manager.
When looking at actively managed equity funds, we always look for alpha - the excess return over benchmark that the fund manager has produced. Alpha is widely regarded as the best metric to measure outperformance. In the Information ratio, we consider not only the alpha but also the degree of variability in the alpha that this fund manager has produced from time to time. If you find one fund with a higher overall alpha but a very large degree of fluctuations in the period-on-period alpha generated by the fund manager, it may just score lower in the Information ratio than another fund with a lower overall alpha but a more stable set of alpha numbers generated period-on-period by the other fund.
Information ratio is in other words nothing but risk adjusted alpha. In our market, since the vast majority of equity funds are actively managed and most of the money collected by fund houses is in various varieties of diversified equity funds, generating alpha has always been the focus of the fund managers. When alpha is a core focus area, it probably follows that the Information ratio should become increasingly a core focus area for analysts and advisors.
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