Definition of Information Ratio
The information ratio measures risk-adjusted return, or how much return you're getting for your investment relative to the risk you take on. It's a variation on a better-known measure of performance known as the Sharpe ratio. The difference is in what you use as the yardstick for measuring both risk and return.
An information ratio helps investors measure the risk-adjusted rate of return for particular investments in their portfolio.
Defining the Sharpe Ratio
To understand the information ratio, it helps to start with the Sharpe ratio. The formula for the Sharpe ratio is (R - Rf)/SD[R]. In the formula, "R" represents the return you've received on your investment -- either in an individual asset or the overall return on your portfolio. "Rf" is the risk-free return, meaning the return available by investing in assets with no risk, such as U.S. Treasury securities.
The result of (R - Rf) is your "excess return" -- the return you get for taking risks. "SD[R]" is the standard deviation of the returns designated by R. Standard deviation is a measure of volatility, or risk. The higher the deviation, the more unpredictable the returns. Taken together, the ratio divides your excess return by your risk.
Identifying Significant Benchmarks
In an article for the CFA Institute, chartered financial adviser Deborah Kidd calls the Sharpe ratio the "industry standard for measuring risk-adjusted return." But it has some shortcomings. A big one is that it offers a comparison only to the risk-free return. Many investors want to know how their risk-adjusted returns compare to noteworthy benchmarks such as the S&P 500.
Investors generally don't judge the success of an investment by comparing it to risk-free options; they compare it to the performance of the financial markets, as measured by things like the S&P. And this is where the information ratio comes in.
Exploring the Information Ratio
The formula for the information ratio is (R - Rb)/SD[R - Rb]. In this formula, "R" is the same as in the Sharpe formula. It's the return you've received on your investment. "Rb" is the return of whatever benchmark you're using. So (R - Rb) is your return beyond the benchmark. This is commonly referred to as "active return" rather than excess return.
Active return can be negative if your return falls short of the benchmark. "SD[R - Rb]" is the standard deviation of your active return -- just how volatile or unpredictable that active return is. Taken as a whole, the ratio divides your active return by the risks you've taken relative to the benchmark.
Interpretation of Results
Information ratios are presented as decimals. The higher the ratio, the better. According to Kidd's review of the literature in the finance profession, an information ratio of 0.5 or above for an investment portfolio is very good, assuming that the appropriate benchmark is being used. However, that level of performance is difficult to maintain for any length of time. Kidd cites a consensus among analysts that a consistent ratio of 0.2 to 0.3 is superior.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.