Steve Pomerantz, LLC

Securities Insight for Attorneys

Information Ratio – What is it and why is it important?

by Steve Pomerantz, PhD

What differentiates a ‘good’ manager from one who is not as good? One of the earliest
measures proposed and still one of the most popular is called the Sharpe Ratio 1, and it is
defined as follows:

Sharpe Ratio = (Rp – r ) / s p

where:
Rp = the return of the portfolio,
r = the risk-free rate, usually chosen as a 1 month T-Bill,
sp = the volatility of the portfolio , usually calculated as the standard
deviation of returns.

The basic idea is that an investment with a higher Sharpe ratio is a better investment. A
higher ratio indicates more return per unit of risk assumed by the manager. But by better,
do we mean that the manager has more skill? Not necessarily, because the investments
could be in completely unrelated types of securities. In an environment where stocks are
outperforming bonds, most stock managers will have a higher Sharpe ratio than the fixed
income counterparts. So it is necessary to compare these ratios on some type of level
playing field, which is usually done by comparing to a relevant index.

To provide some meaning to this ratio, it is best to compare it the Sharpe Ratio for the
investment benchmark. Consider the following example.

The S&P 500 is characterized as a Large Cap index with blended style. Blended means
that it is evenly balanced between the value and growth sectors of the market. Tabled
below is the annualized return and volatility for this index (as represented by the index
fund VFINX), for the five year period ending March 31, 2005. Table 1 lists these values
for several of the top performing mutual funds in this category. 2

Table I
Return Risk Sharpe Ratio
VFINX -3.3 15.6 -.34
MPGFX 12.5 11.6 .91
ASEPX 10.6 11.7 .73
CENSX 9.6 14.3 .53
THPGX 8.6 18.9 .35
VADDX 7.5 14.5 .38

1
Sharpe, William F. “Mutual Fund Performance.” Journal of Business, January 1966, pp119-138.
2
Morningstar.com
 EXHAX 1.5 15.6 -.03

These funds are listed in order of returns from highest to lowest, and with only one small
exception, their Sharpe ratios are in the same order. So if one wanted to order these funds
from better to best, either return or Sharpe would give approximately the same result.

Another popular measure of skill is called alpha, a, and is defined as follows. The returns,
usually monthly, of the fund are regressed on the returns of the benchmark. The slope of
the regression line is referred to as beta, ß, and the intercept is called alpha.

Beta represents the manager’s relative sensitivity to the market. A beta of 1.0 indicates
that a manager’s performance will tend to match the market. If the Beta is greater than
1.0, then the fund will tend to appreciate by more than the benchmark, when the
benchmark has a positive return, and decline by more than the benchmark, when the
benchmark has a negative return.

Alpha represents the average performance of the fund taking into account the funds
general sensitivity to the market, and as such measures the skill of the manager.

Mathematically, the regression equation is of the form:

(Rp-r) = a + ß (Ri-r)
where
Rp = the return on the portfolio,
Ri = the return of the benchmark
r = the risk free rate.

The scatter-plot below illustrates this for the fund VADDX, with the regression line
drawn in.

Monthly Returns

10%
excess return of VADDX

5%

0%

-5%

-10%

-15%
-15% -10% -5% 0% 5% 10%
excess return of VFINX Y = .83x + .0084
For this fund the beta, as represented by the slope of the regression line, is .83; and the
intercept term represents approximately 84 basis points of alpha per month. On an
annualized basis, the alpha would be 10.1%. Table 1 is updated to include this measure as
well:

Table I
Return Risk Sharpe Ratio Alpha
VFINX -3.3 15.6 -.34
MPGFX 12.5 11.6 .91 13.6
ASEPX 10.6 11.7 .73 11.8
CENSX 9.6 14.3 .53 11.2
THPGX 8.6 18.9 .35 12.1
VADDX 7.5 14.5 .38 10.1
EXHAX 1.5 15.6 -.03 4.6

Again we notice that one minor exception, this measure of performance, alpha, seems to
be consistent with the other measures we have calculated.

A closely related concept that also measures ‘beta-adjusted’ performance is the Jensen
Alpha 3. Its definition is similar to the above, but incorporates long term returns rather
than the individual monthly returns.

Jensen’s Alpha is defined as:

Ja = Rp - r - ß(Ri-r).

Modigliani & Modigliani 4 propose a measure of added value that depends only on the
relative risks of the funds and does not incorporate correlation, as the beta does. In their
approach, any excess performance is modified by how much volatility the portfolio
assumed relative to the benchmark. Their risk-adjusted measure is defined as:

M2 = (Rp – Ri) * s i / s p.

Our table, with these new values, continues to show the same basic ranking of funds.

Return Risk Sharpe Alpha Jensen Modigliani

Ratio
VFINX -3.3 15.6 -.34
MPGFX 12.5 11.6 .91 13.6 14.2 21.2
ASEPX 10.6 11.7 .73 11.8 12.2 18.5
CENSX 9.6 14.3 .53 11.2 11.1 14.1
THPGX 8.6 18.9 .35 12.1 11.8 9.8
VADDX 7.5 14.5 .38 10.1 10.3 11.6

3
Jensen, Michael C., “The Performance of Mutual Funds in the Period 1945-1964”, Journal of Finance,23
no2, pp.389 – 416.
4
Modigliani,F. and Modigliani, L., “Risk-Adjusted Performance”, Journal of Portfolio Management,23
no.2 ,pp 45-54.
EXHAX 1.5 15.6 -.03 4.6 11.6 4.9

The measure that we now discuss is called the information ratio, IR, and is perhaps the
most important5. IR attempts to measure not just the excess return to a benchmark, but
also how consistent is that performance. Is a manager beating the benchmark by a little
every month, or a lot in a few particular months? Most investors would prefer the former,
and the IR measures this degree of consistency.

To define the IR we first have to define a related concept called the tracking error. The
tracking error is defined as the volatility, or standard deviation, of monthly excess
returns. The IR is then defined as the excess performance divided by the tracking error.

Mathematically:

tracking error = s p-i

information ratio = (Rp-Ri) / s p-i

When the benchmark for an investment is taken as cash, the information ratio is the same
as the Sharpe ratio.

We now illustrate for our funds the tracking error and information ratios:

Return Risk Sharpe Alpha Jensen Modigliani Tracking Information

Ratio Error Ratio
VFINX -3.3 15.6 -.34
MPGFX 12.5 11.6 .91 13.6 14.2 21.2 10.9 1.45
ASEPX 10.6 11.7 .73 11.8 12.2 18.5 12.2 1.14
CENSX 9.6 14.3 .53 11.2 11.1 14.1 15.3 .85
THPGX 8.6 18.9 .35 12.1 11.8 9.8 11.5 1.03
VADDX 7.5 14.5 .38 10.1 10.3 11.6 7.0 1.55
EXHAX 1.5 15.6 -.03 4.6 11.6 4.9 8.9 .55

The VADDX fund which ranked close to the bottom for the other performance measures
now has the highest value. Even though it’s return and risk-adjusted return is not as high
as those of the other funds. The lower tracking error actually causes it to have the highest
information ratio.

The point of this article is not to confuse the reader with all of these measures, but to
provide a rationale for why the information ratio is so important. A manager with a
higher information ratio can ‘leverage’ their investment process to produce additional
return more efficiently than another manager with a lower information ratio. In other
words, for taking on additional risk, a higher information ratio manager can provide
greater additional return (and alpha as well). An example would be helpful, but first let us
explain what we mean by leveraging an investment process.

5
Grinold, Richard C., “The Fundamental Law of Active Management”, Journal of Portfolio Management,
Spring 1989, pp30-37.
Suppose I represents the benchmark, a collection of stocks (or bonds for that matter) and
P represents the manager’s portfolio. We can form a portfolio, P-ßI , which refers to an
investment that shorts beta dollars of I for every dollar long held in P. This portfolio is
not ‘dollar-neutral’, but it is ‘beta-neutral’ and as such has less risk than a dollar neutral
portfolio. To lever the investment process, an investor would then hold I + k(P-ßI), for
any value of k. The higher the value of k, the more leveraged the portfolio.

This idea is sometimes referred to as portable alpha. Rather than investing in an active
portfolio management style P, one can invest in a passive benchmark investment I, and
also a beta-neutral portfolio P-ßI. The former portfolio I typically has a very low
management fee, while the latter piece provides the Alpha of the investment. The
leverage factor k allows an investor to earn higher returns commensurate with the desired
level of risk.

Now we turn to the question of what affect the information ratio of a process has on these
leveraged portfolios.

Suppose the benchmark has the following statistics:

Ri = 10% s i = 15%.

We now examine two managers with the following statistics:

Manager A: Rp = 10% s p = 15% IR = 0.5,

Manager B: Rp = 10% s p = 15% IR = 1.0.

In this example, each manager has the same risk as the benchmark, the same return as
each other, but Manager B has a higher information ratio. The chart below illustrates the
risk-return of portfolios created with progressively greater values of k, for each of these
managers.

Leveraged Portfolios
60%
50%
40%
Return

30%
20%
10%
0%
10% 20% Volatility 30% 40%

" ir = .5" "ir = 1.0"

For the value of k equal to 0, both of these lines start at the index statistics of 15% for
risk, and 10% for return, but as k increases the manager with a higher information ratio is
generating more return for comparable risk. Alternatively, the chart below illustrates the
alpha of these leveraged portfolios, with the same results.
 Leveraged Portfolios

50%

40%

30%

Alpha
20%

10%

0%
10% 15% 20% 25% 30% 35% 40%
Volatility

" ir = .5" "ir = 1.0"

For both of these measures, we see, that a higher information ratio will allow a manger to
leverage into a better investment.

If we wanted to use different managers to leverage I into a portfolio with a volatility of

20%, we would be creating portfolios with different returns, and performance measures.
Illustrated below are the returns and alphas of the portfolios for these managers. As the
information ratio of the management process increases, so do the returns and alphas for
their respective portfolios. The Sharpe ratio of these portfolios would exhibit the same
features, since they all have the same volatility.

Performance of Portfolios with 20% volatility

30%
25%
20%

15%

10%
5%

0%
0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00
Information Ratio of Process

return alpha

It is also possible to leverage I using different IR processes but maintain a constant

tracking error. In this manner, we create a range of leveraged portfolios that have higher
volatility than the portfolio we start out, but the tracking error remains the same. As the
chart below illustrates, both the returns and alphas improve as the information ratio of the
process being leveraged increases.
 Performance of Portfolios with 6% Tracking Error

25%

20%

15%

10%

5%

0%
0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00
Information Ratio of Process

return alpha

While there are many measures of risk-adjusted performance, and they all have their
strengths and weaknesses, the information ratio is very informative as it highlights which
managers can improve their performance most with the least disruption to their existing
risk.

Steve Pomerantz LLC provides economic consulting and litigation support i n t h e a r e a s o f

securities valuation, investment suitability and investment management performance. Dr.
Pomerantz can be reached at 609.921.7545 or steve@stevepomerantz.com.
www.stevepomeramtz.com