You invest to earn 'good' returns. The word 'good' here is significant. It usually implies two aspects - first, earning sufficient returns to meet your expectations and, second, earning these returns consistently. This is what the information ratio (IR) helps us assess.
The information ratio helps us judge whether a fund manager has achieved superior risk-adjusted returns on a consistent basis. Risk-adjusted return means measuring how much risk has been taken to achieve the returns generated. This is expressed as a number or rating. The higher the information ratio, the better the fund manager’s performance vis-a-vis fund managers of comparable schemes. A higher IR also means better chances of achieving consistent returns.
Computing the information ratio
The information ratio is computed for a specific time period by comparing the active return of a portfolio (the excess return earned in the portfolio due to its active management by a fund manager) against the tracking error (the difference between a portfolio's returns and the benchmark or index it was meant to mimic).
Therefore, Information ratio = Active return of portfolio / Tracking error
where Active return of portfolio = Returns generated by the fund minus Benchmark index returns
and Tracking error = Standard deviation of fund return minus Benchmark index return, i.e. standard deviation of the active return.
Let's understand the information ratio better with an example.
Assume that Fund Manager X achieved an annualized return of 15% with a tracking error of 7% and Fund Manager Y achieved an annualized return of 10% with a tracking error of 3% while the index delivered an annualized return of 4%.
Fund Manager X's IR will be (15% - 4%) = 11% divided by 7% (being the tracking error). This comes to 1.57.
Fund Manager Y's IR will be (10% - 4%) = 6% divided by 3% (tracking error), which gives 2.
Hence, although Fund Manager Y has given lower returns, the portfolio managed by him has a better IR.
Using the information ratio
Keep in mind that the information ratio should be used to compare funds with similar investing styles and objectives. For instance, you can use this ratio to compare two or more diversified equity funds; however, you cannot use it to compare a diversified equity fund to a sector fund.
The information ratio is a good measure to assess a fund manager's performance in terms of risk-adjusted returns.