Information Ratio: Meaning, Formula & How to Calculate

Ratio analysis plays a vital role while investing in the stock market. It helps in selecting stocks or financial instruments to invest in. One of the various ratios that help you understand the nuances of the market is the information ratio. Let us understand the information ratio meaning and how to calculate it.

Understanding Information Ratio

The information ratio is a measure of portfolio or asset performance relative to a benchmark index, compared to the volatility of its returns. A benchmark like this is usually a market index or an index representing any specific industry or sector. This ratio ultimately helps assess how well a portfolio or asset is performing compared to the benchmark and how its returns are exceeding an index’s returns.

This informatio ratio also shows the consistency of an asset or portfolio in generating excess returns than the benchmark index. The consistency of generating excess returns is measured by tracking error. The tracking error reflects if a portfolio can regularly track and surpass its returns generated by the benchmark. A lower tracking error suggests a consistent portfolio, while a higher tracking error shows a more volatile performance.

How to calculate Information Ratio?

You can manually calculate the information ratio using the information ratio formula given below:

IR = (Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking Error

The annualised information ratio can be calculated by multiplying the information ratio by the square root of 252 (the number of trading days in a year). The formula for the same is as follows:

Annualised IR = [(Portfolio Rate of Returns – Benchmark Rate of Returns) / Tracking error] x √252

Steps to Calculate Information Ratio

You can follow the steps given below to calculate the information ratio with data that is unrefined:

1. Note the daily returns earned on a portfolio across a specific window of time.
2. Calculate the average of those returns, which will give you the rate of return.
3. Calculate the index’s rate of return similarly.
4. Deduct the benchmark returns from the portfolio returns to compute the difference i.e. the figure determined by step 3 – the figure determined by step 2.
5. Calculate the standard deviation of the excess returns of such a portfolio
6. Divide the difference in returns by the tracking error to come to the information ratio i.e. figure from step 4 / figure from step 5.

Uses of Information Ratio

• Used by fund managers: Fund manager rely on the Information Ratio to gauge the performance of portfolios. The ratio also helps them determine their service charges.
• Used by traders or investors: Investors use this ratio to ascertain whether their portfolio is providing alpha returns / beating the index due to increased risk. Moreover, the information ratio is also used to measure and compare fund managers’ ability to generate alpha returns.
• Used to analyse investment performance: It can be used as a metric to gauge how your investment is performing and whether the strategy applied is proving to be useful or not. Make sure to do your research and use the tools available to you to invest wisely.