How to Use the Information Ratio Formula to Evaluate Investment Performance
Investing is not an exact science, and evaluating investment performance can be a complicated task. While there are many metrics and ratios that can be used to assess investment performance, one commonly used ratio among professional investors is the information ratio.
The information ratio is a measure of risk-adjusted performance that compares the return of an investment to the risk that was taken to achieve that return. Essentially, it helps investors determine whether their investment returns were worth the risk taken.
In this article, we’ll explore how to use the information ratio formula to evaluate investment performance, along with real-world examples that illustrate the importance of this metric.
What is the Information Ratio Formula?
The information ratio is calculated by dividing the excess return of an investment over a benchmark by the standard deviation of that excess return. In other words, it measures the amount of additional return an investment generated beyond what could be achieved by simply investing in a benchmark, relative to the amount of additional risk taken on.
The formula for information ratio is:
Information Ratio = (Return of investment – Return of benchmark) / Standard deviation of excess return
In this formula, the return of the investment is the total return of the asset or fund, while the return of the benchmark is the total return of an appropriate benchmark index. The standard deviation of the excess return measures the volatility of the investment’s performance compared to the benchmark.
How to Interpret the Information Ratio
A positive information ratio indicates that the investment generated more return than the benchmark, relative to the amount of risk taken on. On the other hand, a negative information ratio indicates that the investment underperformed the benchmark, relative to the amount of risk taken on.
The higher the information ratio, the better the investment’s risk-adjusted performance. A high information ratio indicates that the investment generated significant excess returns above the benchmark, with relatively low risk.
Real-World Examples of Information Ratio
Let’s take a look at some real-world examples to illustrate the importance of information ratio in evaluating investment performance.
Example 1:
Suppose that an investor invested in a mutual fund that generated a total return of 10% over the past year, while the benchmark index returned 8%. The standard deviation of the excess return was 3.5%. Using the information ratio formula, the information ratio of the mutual fund would be calculated as follows:
Information Ratio = (10% – 8%) / 3.5% = 0.57
The information ratio of 0.57 indicates that the mutual fund generated significant excess returns above the benchmark, with relatively low risk.
Example 2:
Suppose that an investor invested in a hedge fund that generated a total return of 12% over the past year, while the benchmark index returned 13%. The standard deviation of the excess return was 6.5%. Using the information ratio formula, the information ratio of the hedge fund would be calculated as follows:
Information Ratio = (12% – 13%) / 6.5% = -0.15
The information ratio of -0.15 indicates that the hedge fund underperformed the benchmark, relative to the amount of risk taken on.
Conclusion
The information ratio is a useful metric for evaluating investment performance, as it measures the amount of additional return an investment generated beyond what could be achieved by simply investing in a benchmark, relative to the amount of additional risk taken on. When evaluating investment performance, it is important to consider not only absolute returns but also risk-adjusted returns, as a high return may come at the cost of significant risk. By using the information ratio formula, investors can gain valuable insights into the risk-adjusted performance of their investments.
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