Searching for Skill: Information Ratio
Relating Return to Risk
If it were impossible for active managers to beat benchmarks there would be no need to evaluate, quantify or rank the degree of manager skill in any active investment strategy. But active managers can and often do beat their benchmarks, demonstrating the potential for active management to add value. The information ratio has gained prominence as a gauge for estimating this potential.
A basic assumption behind this kind of analysis is that, while investors are properly cautioned that past performance is no guarantee of future results, measures of past returns in relation to the risk taken can provide credible evidence to support future expectations.
William Sharpe developed a return-to-risk ratio — now known as the Sharpe ratio — which provided an early means of relating total investment return to risk over time and across asset classes. The information ratio evolved as practitioners sought to evaluate active returns relative to active risk and a convenient way to assess manager effectiveness across a range of similar portfolios or fund categories.
Calculation of Information Ratio
In calculating the information ratio, the mean portfolio return minus the benchmark return equals the manager’s “excess” return over the benchmark, also known as the active return; this excess return is then divided by the variability (standard deviation) of the series of excess returns. The variability is also known as active risk or tracking error. The bigger the result the better. The formula appears below.
Information Ratio = Mean Portfolio Return – Benchmark Return
Evaluating the Information Ratio
How can one know if a manager’s information ratio is respectable? At Voya, where excess return in relation to risk is an important part of performance analysis across all strategies, we track information ratios for our own products and a wide array of competing managers and asset classes. The following table reflects recent results for about 2,000 mutual funds in seven fund categories. About half (911) of the funds had positive ratios over the full 10-year period, laying to rest the question of whether funds ever beat their benchmarks. Average information ratios for high quality (top quartile) managers ranged from 0.07 to 0.67, depending on the asset class/style.
Mutual Fund 10-Year Information Ratios for Periods Ending June 30, 2017
We should note that while the information ratio can reveal the degree to which a manager outperformed his or her benchmark on a risk-adjusted basis, it cannot show how that outperformance was achieved. Further, since the outcome is expressed in terms of the historical returns of both the portfolio and the benchmark, results are highly dependent on the choice of the benchmark and the time period under consideration.
Regardless of the potential limitations, the information ratio has been recognized as the pre-eminent measure of manager skill and, over long periods, the persistence of manager skill. It is equally applicable across most long-only asset classes; but not applicable to strategies with asymmetric or non-normal return distributions such as hedge funds, where use of short-selling and derivatives is common.
If it were easy to pick outstanding managers at random or by intuition, then we wouldn’t need analytic tools such as the information ratio. Experience shows, however, that accurately assessing manager skill takes both qualitative and quantitative research, and the information ratio can be a valuable tool with regard to the latter.
This information is proprietary and cannot be reproduced or distributed. Certain information may be received from sources Voya Investment Management (“Voya IM”) considers reliable; Voya IM does not represent that such information is accurate or complete. Certain statements contained herein may constitute “projections,” “forecasts” and other “forward-looking statements” which do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial data. Actual results, performance or events may differ materially from those in such statements. Any opinions, projections, forecasts and forward-looking statements presented herein are valid only as of the date of this document and are subject to change. Nothing contained herein should be construed as (i) an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Voya IM assumes no obligation to update any forward-looking information.
Past performance is no guarantee of future results.
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