Economics Risk And Return Questions Medium
The information ratio is a measure used in finance to assess the risk-adjusted performance of an investment or portfolio manager. It quantifies the ability of the manager to generate excess returns relative to a benchmark, taking into account the level of risk taken.
The formula for calculating the information ratio is as follows:
Information Ratio = (Portfolio Return - Benchmark Return) / Tracking Error
The portfolio return represents the actual return achieved by the investment or portfolio manager, while the benchmark return represents the return of a specified benchmark index or target. The tracking error measures the volatility or dispersion of the portfolio's returns relative to the benchmark.
A higher information ratio indicates that the investment or portfolio 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 superior stock selection or market timing abilities.
On the other hand, a lower information ratio suggests that the manager has not been able to generate significant excess returns or has taken excessive risk to achieve those returns. It may indicate poor stock selection or market timing abilities.
The information ratio is a useful tool for investors and fund managers to evaluate the performance of investment strategies and make informed decisions about allocating capital. It helps to differentiate between skilled managers who consistently outperform their benchmarks and those who rely on luck or take excessive risks.