1. Mutual Fund Analysis with the Information Ratio
There are two ways of managing mutual fund investments – the active management or the passive management approach. The former manually involves strategizing the fund allocation and timing of the fund transactions, while the latter moves in tandem with the market by investing in an index. The active management adds to your expense ratio (fees) and hence you need to make sure that the fund manager’s approach is contributing positively to the fund performance.
The IR can tell you the reliability and expertise of an asset manager in minimizing the risks and rising above the benchmark. It gauges whether he/she has crossed the benchmark by a higher margin every quarter or smaller margins monthly. Information Ratio weighs how successful the fund house strategy is in its investments and allocations. Using it, you can compare the extra returns made by the mutual fund as opposed to the market fluctuations. In short, a mutual fund investment is more than its returns.
2. How to Calculate the Information Ratio
Step 1: Take the returns per day/month of your mutual fund and the benchmark (I use daily returns) for a specific period.
Step 2: The difference between the returns and the benchmark (whether negative or positive) reveal the performance.
Step 3: Take out the average of the differences (per day/month) for the entire period. This will be the ‘Average’. Then there is the standard deviation from the benchmark (per day/month).
Step 4: Divide the active returns over the benchmark by the volatility of those returns, and you get the Information Ratio. A higher IR indicates a higher active return and vice versa.
3. IR Formula Outcome Analysis
Higher IR is a positive outcome and vice versa. Hence, if your fund yields a better average excess return over lower standard deviation, then it is performing supremely. Don’t forget that the ratio depends on the tenure you consider while calculating. If the benchmark is more than the average, it indicates a negative IR and poor performance.
There is a glaring flaw of IR, which can mislead investors if they do not use any other analytics. Sometimes, even a negative IR can outstrip the benchmark or a fund with a higher information ratio falls behind the benchmark. This happens because IR considers only mathematic average without counting the compounded returns. Never consider the active returns vs benchmark alone. It is more important to look for consistency of IR over a period of time.
4. Why IR is a Reliable Tool to Help You Choose the Best Mutual Fund
a. The Information Ratio is more practical and accurate compared to tools like Sharpe Ratio. It doesn’t merely measure and compare returns and benchmark but also adjusts the results as per market volatility.
b. While the Sharpe Ratio merely reveals how much investors get compensated for the risks endured, the IR divulges how much the asset manager yielded by benchmark deviation.
c. The greater the Information Ratio is the better and constant the performance. Looking for consistency is vital as investors enter and exit at different times – this shouldn’t impact the performance.
d. more dependable and better performing fund, which will give a more consistent investor experience. This is important as investors come in at different points in time.
e. Investors interested in the small-cap and mid-cap mutual fund space must be especially aware of the contextual risks and historic performance and IR is the best tool to assess them.
5. Information Ratio and Your Portfolio
There is one more term you need to understand before you use the Information Ratio to build your portfolio. This is the ‘Alpha’.
According to experts, the Alpha is defined as a measurement of a fund’s performance calculated on a risk-adjusted basis. When calculating the Alpha, one takes volatility of a mutual fund – also known as the price risk – and compares it to a benchmark index.
So, the excess return that a fund generates relative to the return generated by the benchmark index is therefore known as the Alpha. Thus, by using the Information Ratio correctly you can pick the best mutual funds and investment managers for your portfolio. For instance, if you notice that fund A has a higher Alpha return than fund B according to a market analysis, then you should choose fund A for your portfolio.;