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The Information Ratio is the ratio of the alpha component of total returns to the standard deviation of these excess alpha returns. The alpha component is the return that is attributable to the manager skill to time the market and is the residual after taking out the risk free return and the beta components from the total returns. While the Sharpe ratio considers the standard deviation of the total returns, the information ratio considers the variability of only the alpha component of the return (which also forms the numerator). In other words, the information ratio is merely Jensen alpha divided by its standard deviation.
| = |
ER[a] - ER[b]
The higher the information ratio, the greater the chances of the manager to make money in the future. The information ratio only looks to compute the return per unit of risk undertaken for the alpha component. This is important because alpha returns are risky, as they represent a zero sum game for the market as a whole. In fact, average alpha for the market as a whole is in practice slightly less than zero because of transaction and other costs. Therefore it is easy for a manager to take on ?alpha risk? and lose money that will bite into the beta returns.
Information Ratio In A Nutshell
This begins the endeavor into the weeds of finding which investment is going to fit your current portfolio. Beyond benchmark performance, you want to keep in mind the expense ratio and other costs associated with the particular. Reading the information ratio is simple, the higher the number the better the product has done against the respective benchmark.
With the many different products out there, people are always asking how the particular fund is giving them an edge in the market. More specifically with ETF’s and mutual funds, many wonder how they are beating the benchmark and how often they are doing so. The information ratio seeks to give us an answer to this question by measuring how a portfolio fairs compared its respective benchmark.
Closer Look at Information Ratio
The number itself may not tell you the whole story so it is critical that you dig a little deeper. As an investor, you want to understand the risks and how the company is achieving outperformance. It could be from leveraging or other practices, so it is crucial that those align with your investing views.
Using the information ratio a reasonable way to begin narrowing your search for potential investments. You may also find that the sharp ratio is another effective way to find the appropriate portfolio to invest in. Pick apart the portfolio understanding the reason for the holdings and what is involved with the selection process. Also look at the track record of the manager and see if they have a history of success. All of these factors are important to consider when looking for a particular fund.