Information ratio

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The Information Ratio concept is one measure of volatility-adjusted return and is used in the analysis of performance of mutual funds, hedge funds, etc. Specifically, the information ratio is defined as excess return divided by tracking error. Excess return is the amount of performance over or under a given benchmark index. Thus, excess return can be positive or negative. Tracking error is the standard deviation of the excess return.

The ratio compares the annualized returns of the Fund in question with those of a selected benchmark (e.g, 3 month Treasuries). Since this ratio considers the annualized standard deviation of both series (as measures of risks inherent in owning either the fund or the benchmark), the ratio shows the risk-adjusted excess return of the Fund over the benchmark. The higher the Information Ratio, the higher the excess return of the Fund, given the amount of risk involved, and the better a Fund manager. This ratio is calculated as:

Information Ratio = (AnnRtn(r₁, ..., r_n) - AnnRtn(s₁, ..., s_n)) / AnnStdDev(e₁, ..., e_n)

where:

r₁, ..., r_n = manager return series
s₁, ..., s_n = benchmark return series
e₁, ..., e_n = r₁ - s₁, ..., r_n - s_n

The Information ratio is similar to the Sharpe Ratio, but there is a major difference. The Sharpe Ratio compares the return of an asset against the return of Treasury bills, but the Information Ratio compares excess return to the most relevant equity (or debt) benchmark index.