How's That Fund Doing? Check the Information Ratio
As of mid-2023, more than seven in 10 IRA-owning households held mutual funds and more than three in 10 held exchange-traded funds (ETFs) in their traditional or Roth IRAs, according to surveys conducted by the Investment Company Institute.
It's one thing to look at how a fund performs day to day—and many investors do—but there's more to learn. For instance, it's important to know how well a fund and its manager are doing against their closest peers and the market as a whole. For that, you'll need a few more tools. The Information ratio is one critical measure individual and professional investors can use to keep an eye on fund performance and fund manager consistency.
What is the Information ratio?
The Information ratio (IR) measures the risk-adjusted returns of a particular asset or portfolio against a certain benchmark like the S&P 500® index (SPX). In addition, the IR uses a different calculation called the "tracking error," or the measure of how much risk is being assumed to generate the fund's returns over its benchmark. IR can also be seen as a measure of the portfolio manager's skill at picking investments and their success over time, typically referred to as consistency of returns. It's the same thinking whether you're managing billions—or just tens of thousands, according to Viraj Desai, director of Charles Schwab Investment Management. "The beauty of the information ratio is that in one glance, it gives you a picture of a fund manager's performance relative to a specific benchmark as well as the consistency of its returns over time," he added.
Desai suggested a fund manager should have at least three years of experience managing a particular fund for this ratio to be worthwhile and explained "the longer a fund manager's track record, the more dependable the IR will be for a given fund investment." (You can find additional information about the fund manager in the fund's fact sheet or prospectus).
How to calculate the Information ratio
The Information ratio measures the risk-adjusted returns of an actively managed investment versus a market benchmark—for many, it's the SPX. The IR can tell you which fund managers have a track record of consistently beating that chosen benchmark (or possibly undershooting it). Either way, the IR is both a measure of a fund manager's skill (picking the right funds) and their performance consistency over time.
For example, let's say your stock fund is currently beating the SPX by 3%. That 3% is known as the active, or "excess," return. But to understand what looks like a very good active return, investors should understand the level of risk a manager has taken on in beating the index—a.k.a the tracking error.
Funds with a lower tracking error generally indicate that a portfolio manager is staying close to their benchmark and taking fewer risks to beat it. Higher excess returns at a lower risk generally produce a higher IR.
And that, said Desai, is what investors should aim for.
Here's the Information ratio formula:
(Rp – Rb) ÷ TE
Key:
Rp: Investment return (actual or forecast)
Rb: Return of a benchmark like the SPX/MSCI ACWI/AGG
TE: The portfolio's tracking error (the standard deviation of the difference between an investment's returns and the benchmark's returns, or essentially the risk taken on in trying to beat the benchmark)
Which benchmarks should you use?
Because it's a key ingredient in the IR formula, your choice of benchmark is critical to determining whether the IR history of a fund makes it right for your portfolio.
For an equity fund, the SPX is the touchstone for U.S. stocks, while for global equities, most fund managers use the MSCI All-World Index ETF (ACWI). For a fixed income or bond portfolio, most managers rely on the Barclays Aggregate Bond Index (AGG) as their benchmark.
A tale of two funds
Let's compare two funds' IRs. Which would you choose?
Fund 1
- Estimated 12-month return: 15%
- SPX return: 10%
- Tracking error: 15%
- Calculation: (0.15 – 0.10) ÷ 0.15 = IR of 0.33
Fund 2
- Estimated 12-month return: 12%
- SPX return: 10%
- Tracking error: 4%
- Calculation: (0.12 – 0.10) ÷ 0.04 = IR of 0.50
What do the results say?
Fund 1 has a higher estimated annual return of 15% compared to a 12% return for Fund 2. Investors chasing returns would most likely pick Fund 1 for that reason alone. However, due to its high tracking error (risk/volatility), Fund 1 has an IR of only 0.33—just below what experts consider a desired range (0.4 to 0.6). This suggests that Fund 1's returns are more volatile and less consistent than Fund 2's.
The question to ask might be, "Am I more interested in higher returns with a high degree of volatility, or do I want attractive returns with lower volatility and greater consistency?" The higher IR (0.5) for Fund 2 suggests it has the better potential to produce market-beating returns with low volatility and greater consistency over time.
" id="body_disclosure--media_disclosure--194676" >Let's compare two funds' IRs. Which would you choose?
Fund 1
- Estimated 12-month return: 15%
- SPX return: 10%
- Tracking error: 15%
- Calculation: (0.15 – 0.10) ÷ 0.15 = IR of 0.33
Fund 2
- Estimated 12-month return: 12%
- SPX return: 10%
- Tracking error: 4%
- Calculation: (0.12 – 0.10) ÷ 0.04 = IR of 0.50
What do the results say?
Fund 1 has a higher estimated annual return of 15% compared to a 12% return for Fund 2. Investors chasing returns would most likely pick Fund 1 for that reason alone. However, due to its high tracking error (risk/volatility), Fund 1 has an IR of only 0.33—just below what experts consider a desired range (0.4 to 0.6). This suggests that Fund 1's returns are more volatile and less consistent than Fund 2's.
The question to ask might be, "Am I more interested in higher returns with a high degree of volatility, or do I want attractive returns with lower volatility and greater consistency?" The higher IR (0.5) for Fund 2 suggests it has the better potential to produce market-beating returns with low volatility and greater consistency over time.
What's a good IR?
In simplest terms, the IR shows how much a fund or ETF beat its benchmark index on a risk-adjusted basis. Examined more closely, the tracking error (the denominator in the equation) reveals the consistency of a fund's returns over time.
Desai said "an IR between 0.4 and 0.6 is a good range for a fund's potential inclusion in a portfolio, all else being equal."
Positive IR ranges:
- An IR of 0.4 or above is considered good.
- 0.70 or above is very good.
- 1.0 or higher is exceptional.
Putting the IR in perspective:
- The higher the IR (>0.4), the better because it shows the fund is beating its benchmark with respectable consistency.
- A low IR (<0.3) may still be a worthwhile investment given your objectives, but it suggests greater volatility and a higher tracking error, which generally means less consistency in beating the benchmark.
- Any investor can use the IR to compare funds.
According to Desai, "The last thing a portfolio manager wants to see is years of sub-performance, followed by one or two years of excess returns over the benchmark that ends up producing an IR that looks ostensibly attractive."
So, IR users should be prepared to look backward and dig deeper before it's time to buy.
Sharpe ratio vs. IR for fund evaluation—Which is best?
The two ratios are similar in that they both seek to show the risk-adjusted returns of an actively managed investment fund or ETF. The difference? The Sharpe ratio seeks to compare a fund's returns against a cash rate, while the IR compares a fund's returns against a benchmark index.
So, which to choose? All ratios have their strong points but are limited by historical data, the future of which cannot be guaranteed.
Desai suggested using both the Sharpe and Information ratios because the IR "is only one piece of a mosaic and not an on/off switch. Each ratio you incorporate gives you a chance to see a potential investment from a different perspective." The same could be said of the Sharpe ratio, also a foundational metric, as it's only one data point among many investors should consider.
A Sharpe ratio above 1 can often be associated with fixed income and might not be the best guidance, particularly for an aggressive investor. Desai said, "If you want a baseline measure of risk-adjusted returns you can start by comparing Sharpe ratios, and then if you want a measure of how portfolio managers take risk on a risk adjusted basis, you can use the Information ratio."
Bottom line
As you sift through the universe of actively managed funds, the Information ratio and the Sharpe ratio can give you an easily understood foundation for fund performance comparison. Both ratios factor in risk-adjusted performance that can help you avoid unnecessary volatility as you aim for excess returns beyond the benchmark.