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They say the mutual fund is one of the most painless financial products to invest in as the fund manager takes care of everything. However, it is important to perform regular checks on your own, too. This is essential to understanding where you stand and making logical predictions about your investments. While the benchmark index is a basic tool to analyze the fund performance, it should not be the final word for a serious investor. There are other tools like Information Ratio (IR) to further assess the performance of the scheme.
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.
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.
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.
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.;