Understanding the Information Ratio

Understanding the Information Ratio

The information ratio compares portfolio returns that exceed a benchmark to the volatility of those returns. Let me explain what the information ratio (IR) really is. It measures a fund manager's returns against a benchmark and the volatility, or consistency, of those returns.

You might see raw return figures showing a fund beat its benchmark by a certain percentage over time, but the IR helps you figure out to what degree that outperformance came from taking on risk and if the results were consistent. This tells you if you're getting good value when you pay more for an actively managed fund.

Key Points on the Information Ratio

The IR helps you decide if paying higher fees for actively managed funds is worth it. If you see a higher IR, typically above 0.5, it suggests the fund manager is consistently generating returns above their benchmark.

To make it meaningful, look at information ratios covering at least three years of a fund manager's performance—longer track records give you a better sense of their abilities. Unlike the Sharpe ratio, which compares returns to risk-free investments like Treasury bills, the IR measures risk-adjusted performance against benchmarks like the S&P 500 index.

Formula and Calculation of the Information Ratio

While the IR is a handy way to evaluate an actively managed fund, some people shy away from the math, but it's straightforward. It answers two questions: Did the fund beat the market, and was it just luck? The formula is IR = (Portfolio Return - Benchmark Return) / Tracking Error, where Portfolio Return is the return for the period, Benchmark Return is the benchmark's return, and Tracking Error is the standard deviation of the difference between portfolio and benchmark returns.

Subtract how well the benchmark did from how well your investment did to get the excess return. Then divide that by the tracking error, which shows how consistent those excess returns are.

A Warning on Tracking Error

Be careful with tracking error here. For passive index funds, it measures how closely it follows the benchmark, often a small percentage. But in the IR formula, tracking error measures the consistency of a fund's excess returns. For instance, if a fund beats its benchmark by 2% every month, it has a low tracking error in this context, even if it's not matching the index. If another fund beats by 10% one month and underperforms by 6% the next, it has a higher tracking error, even with the same average outperformance.

Comparing Information Ratios

Suppose you're comparing two mutual funds that both claim to beat the S&P 500. Let's say the S&P 500 returned about 10%. For the Steady Growth Fund with a 12% annual return and 4% tracking error, the IR is (12% - 10%) / 4% = 0.50. For the Wild Ride Fund with 15% return and 15% tracking error, it's (15% - 10%) / 15% = 0.33.

The Wild Ride Fund looks better at first with higher returns, but its lower IR shows more inconsistency and risk. The Steady Growth Fund's higher IR indicates it's more consistent and potentially a better choice.

Real-World Example with Fidelity Contrafund

Take the Fidelity Contrafund (FCNTX), a popular large-cap growth mutual fund. To calculate its IR, you need the fund's annual returns, the S&P 500 benchmark returns, and the tracking error as the standard deviation of the excess returns.

Using data from 2015 to 2024, the average annual excess return is 5.17%, tracking error is 9.36%, so IR = 5.17% / 9.36% = 0.55. This means over 10 years, the fund generated excess returns relative to the risk, with strong years outweighing underperforming ones. Different periods give slightly different IRs, like 0.72 for three years and 0.53 for five, but they're all solid, showing consistent outperformance by manager Will Danoff.

A Tip for Using Periods

Using different period lengths will give you different IRs. Financial publications often report them over one-year, three-year, and five-year periods. Longer periods generally offer a more reliable track record for measuring a fund manager's skill.

Your Shortcut to IR

Calculating IR requires some spreadsheet work, but for a less precise way, just look at charts in the fund's prospectus comparing annual or quarterly returns vs. the benchmark. This gives you a quick sense of consistency without the full math.

IR vs. Sharpe Ratio

The IR and Sharpe ratio both check risk-adjusted returns, but differently. The Sharpe ratio looks at excess return over a risk-free rate divided by total volatility. The IR focuses on excess return over a benchmark divided by the volatility of those excess returns, or active risk.

Key differences: Sharpe uses risk-free benchmarks and total risk, while IR uses market benchmarks and active risk. Sharpe is for overall portfolios, IR for active managers against benchmarks.

The Bottom Line

The IR helps you assess if a fund manager consistently delivers value for higher fees. Fidelity Contrafund's 10-year record shows why this matters—it's been consistent. Don't just chase high recent returns; use IR to find steady outperformance with lower volatility. Remember, past performance doesn't predict the future, and consult a financial advisor before investing.