Information ratio

The information ratio is the more general form of the Sharpe ratio (formula and detailed description). It is used as a risk adjusted measure of the relative performance of a portfolio. It is straightforward to calculate given historical price data and pre-calculated information ratios for funds are widely available.

The information ratio deducts the effect of market movements from returns and adjust for the risk taken. This makes it a single number that neatly summarises the element of performance that can be attributed to good management — it is similar to alpha. It also has the advantage that it does not depend on the period over which it is measured. This means that when comparing a fund that only has a short history with one that has a long history, once can directly compare the information ratios calculated using the full histories of both funds — using the most accurate number for each.

The choice of benchmark is usually straightforward, but may matter. For example, a fund may have out-performed the market, but only performed in line with a suitable style index. What is more appropriate depends on whether you wish to evaluate the strategy as well as the manager’s stock picking abilities, or only the latter. Style drift may also cause distortions.

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