During my recent “Zephyr StatFacts” version of the “Adjusted for Risk” podcast I focused on the Information ratio. Below are the show notes and additional supporting information on why I believe Information ratio should be one of the return-risk trade-off metrics you turn to when conducting a manager search or due diligence.
The information ratio is a benchmark-relative, return-versus-risk metric, the Information ratio measures the excess return against the benchmark divided by tracking error, where tracking error is a measure of consistency.
How Is it Useful?
One of the reasons why I really like the Information ratio and find it very useful is that it answers the two most important questions for an active manager. First, did the manager outperform the passive benchmark? Second, was the manager able to outperform the benchmark consistently? If the answer to either of these is “no,” then a low-cost passive product like an index fund or an ETF might make sense. Therefore, the Information ratio stands as a great way to justify an active manager’s existence.
What is a good number?
The higher the Information ratio, the better. If the Information ratio is less than zero, it means the active manager failed on the first objective of outperforming the benchmark. Of all the performance statistics, the Information ratio is one of the most difficult hurdles to clear. Generally speaking, an Information ratio in the 0.40-0.60 range is considered quite good. Information ratios of 1.00 for long periods of time are rare. Typical values for Information ratios vary by asset class. Details are provided on the reverse side.
What Are the Limitations?
The Information ratio is a benchmark-relative statistic. It is entirely possible for a manager to have a high Information ratio, but still exhibit significant losses if the benchmark is down. Because the information ratio is benchmark relative, it’s imperative that the benchmark used in the analysis is appropriate in order for the information ratio to be relevent. Because of that you must also compare like managers, or apples to apples comparisons.
What Do the Graphs Show Me?
The top graph displays the numerator, the excess return over the benchmark. The thick black line is the benchmark, and the red and blue lines show the rolling excess returns for two different managers. The bottom graph shows the denominator, which is the tracking error versus the benchmark. The smaller the tracking error, the more consistent the excess returns.
With the red manager, we see that the excess return is higher overall than the blue manager. However, we see the red manager’s excess return pattern is much more erratic, resulting in a higher tracking error. In contrast, the blue manager’s excess returns are lower, but much more consistent. Therefore, the blue manager has a higher Information ratio than the red manager.
What Are Typical Values?
Below are the ranges of 10-year Information ratios across six asset classes. Peer groups of separately managed account composites are compared to their relevant benchmarks. The difficulty of achieving a high Information ratio stands out. The median manager typically has an Information ratio near or below zero. It is quite rare to see managers with Information ratios in excess of 1.00 over long time periods.