What's the Information Ratio? How Investors Use It

The information ratio (IR) measures a fund manager's ability to generate excess returns relative to a benchmark after adjusting for the volatility (standard deviation) of those returns, called "tracking error." Essentially, it assesses if active investing decisions consistently added value relative to the chosen benchmark, like the S&P 500^® Index (SPX) or the Bloomberg U.S. Aggregate Bond Index.

As a result, the IR is often seen as a measure of a portfolio manager's skill at selecting investments. For example, if an equity ETF is currently beating the SPX by 3%, that 3% is considered the active, or "excess," return. However, to properly evaluate this ETF, investors must consider the risk the fund manager took to achieve that 3% excess return—and the consistency of their results.

A high IR indicates a fund manager is efficiently and consistently delivering excess returns for investors, while a low IR suggests the manager is taking on risk without delivering proportional outperformance relative to their benchmark.

"The beauty of the information ratio is that in one glance, it gives you a picture of a fund manager's performance," said Viraj Desai, director at Charles Schwab Investment Management.

Desai said a fund manager should have at least three years of experience managing a particular fund for this ratio to be worthwhile: "The longer a fund manager's track record, the more dependable the information ratio will be for evaluating a given fund investment."

Investors can find additional information about fund managers in their funds' fact sheets and prospectuses.

To calculate the information ratio, find the difference between a fund's return and its benchmark's return. This is the active, or excess, return. Then divide that number by the tracking error, which is the standard deviation (or volatility) of the active return.

Here's the IR formula:

(Rp – Rb) ÷ TE

Key:

• Rp: Investment return (actual or forecast)
• Rb: Benchmark return
• (Rp – Rb): Active return
• TE: Tracking error = Standard deviation of (Rp - Rb)

Note: The tracking error can be found in a fund's fact sheet and is typically listed as the "standard deviation."

The benchmark used to evaluate a fund's active return is a key ingredient in the IR formula. While funds typically select their own official benchmark—often defined in the prospectus as the target for performance—investors can also select an alternative benchmark to calculate the IR.

For U.S. equity funds, the SPX is the most common benchmark, while the MSCI All-Country World Index ETF (ACWI) is popular for global equities. Many investors rely on the Bloomberg U.S. Aggregate Bond Index as their benchmark for fixed income or bond funds.

As long as the benchmark choice is relevant to the fund's strategy and risk profile, a custom benchmark can help investors assess a fund's performance consistency and its manager's skill.

In general, the higher the IR, the better because it shows a fund is consistently beating its benchmark. A low IR (<0.3) may still be a worthwhile investment depending on an investor's objectives, but it suggests a fund has experienced greater volatility in beating its benchmark.

Generally, an IR between 0.4 and 0.6 is considered good, above 0.6 is very good, and above 1.0 is exceptional, indicating consistent outperformance.

Guideline IR ranges:

• ≤ 0.0: Poor
• 0.0 – 0.4: Low to average
• 0.4 – 0.6: Good
• 0.6 – 1.0: Very good
• > 1.0: Exceptional

While these general guideline IR ranges can help investors quickly assess the skill of a fund manager, they should always be viewed in context. The benchmark selected and the evaluation time frame can make a manager look better or worse than they are.

Desai explained that sometimes years of underperformance can be masked by one or two years of strong excess returns over the benchmark. These years can produce an IR that appears attractive but may be misleading.

To get a clearer picture of a fund manager's performance, investors should consider tracking their fund's IR over time, comparing their IR to peers in the same asset class and category, and using other complementary metrics like the Sharpe ratio or Sortino ratio, which tracks risk-adjusted returns, but relative only to downside risk.

The Sharpe ratio and the information ratio are similar in that they both seek to measure risk-adjusted returns. However, the Sharpe ratio compares a fund's risk-adjusted return against the so-called risk-free rate, usually the 10-year Treasury yield, while the IR compares a fund's excess risk-adjusted return against a specific benchmark index like the SPX.

These two ratios ultimately address two questions for investors. The Sharpe ratio seeks to answer whether investors were adequately compensated for the risk taken by the fund, while the information ratio shows whether a fund manager was able to consistently produce excess returns relative to a benchmark.

Desai suggests using both the Sharpe and information ratios, noting they each have their strengths but are limited by their use of historical data, which may not reflect future performance. "The information ratio 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.

As investors sift through the universe of actively managed funds, the information ratio and the Sharpe ratio can provide an easily understood foundation for fund performance comparison. Both ratios factor in risk-adjusted performance and may help investors avoid unnecessary volatility as they aim for excess returns beyond a benchmark.

However, these ratios should only be viewed as the starting point for deeper analysis. Before investing in any fund, investors should always ensure they understand its investment strategy, performance track record, fees, and risks.