Want to Check Out a Fund—or a Fund Manager? The Information Ratio Offers a Close-Up on Performance Over Time

By the end of 2022, more than half of American households owned mutual funds and 12% owned exchange-traded funds (ETFs), according to the Investment Company Institute.

It’s one thing to look at how a fund does day to day—and many investors do—but there’s more to learn. For instance, it’s important to know how well a fund and its manager are doing against their closest peers and the market as a whole. For that, you’ll need a few more tools. The Information ratio is one critical measure individual and professional investors can use to keep an eye on fund performance and fund manager consistency.

What is the Information ratio?

The Information ratio (IR) measures the risk-adjusted returns of a particular asset or portfolio against a certain benchmark like the S&P 500® index (SPX). In addition, the IR uses a different calculation called the “tracking error,” or the measure of how much risk is being assumed to generate the fund’s returns. The IR can be seen as a measure of the skill in picking investments, while the tracking error is seen as a measure of the portfolio’s volatility and consistency, typically referred to as consistency of returns.

It’s the same thinking whether you’re managing billions—or just tens of thousands. The beauty of the Information ratio is that in one glance, it gives you a picture of a fund manager’s performance relative to a specific benchmark as well as the consistency of its returns over time.

It’s common industry practice for a portfolio manager to have at least three years of experience managing a particular fund for this ratio to be worthwhile. The longer a fund manager’s track record, the more dependable the IR will be for a given fund investment. (You can find additional information about the fund manager(s) in the fund’s fact sheet or prospectus).

How to calculate the Information ratio

The Information ratio measures the risk-adjusted returns of an actively managed investment versus a market benchmark—for many, it’s the SPX. The IR can tell you which fund managers have a track record of consistently beating that chosen benchmark (or possibly undershooting it). Either way, the IR is both a measure of a fund manager’s skill (picking the right securities) and their performance consistency over time.

For example, let’s say your stock fund is currently beating the SPX by 3%. That 3% is known as the active, or “excess,” return. But to understand what looks like a very good active return, investors should understand the level of risk a manager has taken on in beating the index—aka the tracking error. The excess return divided by the tracking error is the measure of the overall skill in picking investments over time. 

Funds with a lower tracking error generally indicate higher consistency and lower risk, which is also referred to as volatility. Higher returns at a lower risk generally produce a higher IR, which is what investors should be aiming for.

Here’s the Information Ratio formula:

(Rp - Rb) ÷ TE

Key:                                                                                                                         

• Rp: Portfolio return (actual or forecast)
• Rb: Return of a benchmark like the SPX
• TE: The portfolio’s tracking error (the standard deviation of the difference between an investment’s returns and the benchmark’s returns, or essentially the risk taken on in trying to beat the benchmark)

Which benchmarks should you use?

Because it’s a key ingredient in the IR formula, your choice of benchmark is critical to determining whether the IR history of a fund makes it right for your portfolio.  

For an equity fund, the SPX is the touchstone for U.S. stocks. For other assets, other benchmarks are appropriate.

What’s a good IR?

In simplest terms, the IR shows how much a fund or ETF beat its benchmark index. Examined more closely, the tracking error (the denominator in the equation) reveals the consistency of a fund’s returns over time.  

A market norm for the IR is between 0.4 and 0.6, which is a good range for a fund’s potential inclusion in a portfolio, all else being equal.

Positive IR ranges:

• An IR of 0.4 or above is considered good.
• 0.70 or above is very good.
• 1.0 or higher is exceptional.

Putting the IR in perspective:

• The higher the IR (>0.4), the better, because it shows the fund is beating its benchmark with respectable consistency.
• A low IR (<0.3) may still be a worthwhile investment given your objectives, but it suggests greater volatility and a higher tracking error, which generally means less consistency in beating the benchmark.
• Any investor can use the IR to compare funds.

So, IR users should be prepared to look backward and dig deeper before it’s time to buy.

Sharpe ratio vs. Information ratio for fund evaluation—Which is best?

The two ratios are similar in that they both seek to show the risk-adjusted returns of an actively managed investment fund or ETF. The difference? The Sharpe ratio seeks to compare a fund’s returns against a risk-free rate, while the IR compares a fund’s returns against a benchmark index.

So, which to choose? All ratios have their strong points but are limited by historical data, the future of which cannot be guaranteed.

We suggest using both the Sharpe and Information ratios because the IR is only one piece of a mosaic and not an on/off switch. Each ratio you incorporate gives you a chance to see a potential investment from a different perspective. The same could be said of the Sharpe ratio, also a foundational metric, as it’s only one data point among many investors should consider.

Traders could consider zeroing in on funds with a Sharpe ratio above 1.0 and an IR between 0.4 to 0.6. Both of those levels are the minimum acceptable performance ratio levels that many professional fund managers use when making decisions. A fund matching those parameters might warrant further inspection.

The bottom line

As you sift through the universe of actively managed mutual funds and ETFs, the Sharpe ratio and the Information ratio can give you an easily understood foundation for fund performance comparison. Both ratios factor in risk-adjusted performance that can help you avoid unnecessary volatility as you aim for excess returns.