what the ir can tell you
the information ratio identifies how much a fund has exceeded a benchmark higher information ratios indicate a desired level of consistency whereas low information ratios indicate the opposite many investors use the information ratio when selecting exchange traded funds etfs or mutual funds based on their preferred risk profiles of course past performance is not an indicator of future results but the ir is used to determine whether a portfolio is exceeding a benchmark index fund the tracking error is often calculated by using the standard deviation of the difference in returns between a portfolio and the benchmark index standard deviation helps to measure the level of risk or volatility associated with an investment a high standard deviation means there is more volatility and less consistency or predictability the information ratio helps to determine how much and how often a portfolio trades in excess of its benchmark but factors in the risk that comes with achieving the excess returns with the fees being charged by active fund managers more investors are turning to passively managed funds that track benchmark indexes like the s p 500 some investors are paying 0 5 to 2 annually for an actively managed fund by a fund manager it s important to determine whether the fund is beating a similar benchmark index on a consistent basis the ir calculation can help provide a quantitative result of how well your fund is being managed the difference between the ir and the sharpe ratiolike the information ratio the sharpe ratio is an indicator of risk adjusted returns however the sharpe ratio is calculated as the difference between an asset s return and the risk free rate of return divided by the standard deviation of the asset s returns the risk free rate of return would be consistent with the rate of return from a risk free investment like a u s treasury security if a particular treasury security paid a 3 annual yield the sharpe ratio would employ 3 as the risk free rate for comparative purposes the ir on the other hand measures the risk adjusted return in relation to a benchmark such as the standard poor s 500 index s p 500 instead of a risk free asset the ir also measures the consistency of an investment s performance however the sharpe ratio measures how much an investment portfolio outperformed the risk free rate of return on a risk adjusted basis both financial metrics have their usefulness but the index comparison makes the ir more appealing to investors since index funds are typically the benchmark used in comparing investment performance and the market return is usually higher than the risk free return as with all financial ratios using one to determine the suitability of an investment is not recommended utilizing multiple financial metrics to assess an investment is a more prudent approach limitations of using the irany ratio that measures risk adjusted returns can have varied interpretations depending on the investor each investor has different risk tolerance levels and depending on factors such as age financial situation and income might have different investment goals as a result the ir is interpreted differently by each investor depending on their needs goals and risk tolerance levels also comparing multiple funds against a benchmark is difficult to interpret because the funds might have different securities asset allocations for each sector and entry points in their investments as with any single financial ratio it s best to look at additional types of ratios and other financial metrics to make a more comprehensive and informed investment decision example of how to use the ira high ir can be achieved by having a high rate of return in the portfolio as compared to a lower return in the index as well as a low tracking error a high ratio means that on a risk adjusted basis a manager has produced better returns consistently compared to the benchmark index for example say you re comparing two different fund managers fund manager a s ir equals 1 81 or 13 1 5 8 fund manager b s ir equals 2 11 or 8 1 5 4 5 although manager b had lower returns than manager a their portfolio had a better ir because in part it has a lower standard deviation or tracking error which means less risk and more consistency of the portfolio s performance relative to the benchmark index 