Economics Risk And Return Questions Medium
The information ratio is a measure used to evaluate the performance of an investment manager or portfolio. It assesses the manager's ability to generate excess returns relative to a benchmark, taking into account the level of risk taken. The information ratio is calculated by dividing the excess return of the portfolio by the tracking error.
The formula for calculating the information ratio is as follows:
Information Ratio = (Portfolio Return - Benchmark Return) / Tracking Error
Where:
- Portfolio Return is the actual return achieved by the investment portfolio.
- Benchmark Return is the return of a chosen benchmark index or a relevant market index.
- Tracking Error is a measure of the volatility or dispersion of the portfolio's returns relative to the benchmark. It quantifies the extent to which the portfolio deviates from the benchmark.
A higher information ratio indicates that the investment manager has been able to generate greater excess returns relative to the benchmark, considering the level of risk taken. It suggests that the manager has added value through active management and has the potential to outperform the benchmark consistently. Conversely, a lower information ratio implies that the manager has not been able to generate significant excess returns or has taken excessive risk to achieve those returns.
It is important to note that the information ratio should be interpreted in conjunction with other performance measures and factors such as the investment manager's investment style, investment horizon, and market conditions. Additionally, the information ratio is most useful when comparing managers or portfolios within the same asset class or investment strategy.