A member of the freefincal investor circle asks: Can information ratios be used for index fund analysis?
What is Information Ratio? This is a measure of outperformance per unit risk associated with outperformance. In other words, the information ratio is a risk-adjusted measure of a fund manager’s effectiveness outperforming its benchmark.
How is the information ratio calculated? Calculating the information ratio requires the following steps:
- Calculate daily or monthly returns for a fund and benchmark over a specified time period (I use daily returns).
- Calculate the difference between two. Excess return for active funds. For passive funds, this should be a low negative number.
- Calculates the average difference in earnings over the period.
- Calculate the standard deviation of the difference in returns. This is also known as tracking error or relative volatility. It measures how much individual excess returns deviate from the average.
Information Ratio = Mean Return Difference divided by Tracking Error.
Or, average excess return divided by the volatility associated with the excess return. It can be defined in a slightly more readable way as:
βinformation ratio =(Portfolio returnβbenchmark return)/tracking error
This information ratio is part of a comprehensive mutual fund analysis tool for members of the Freefincal Investor Circle.
In contrast, the Sharpe ratio also calculates the excess return per unit average risk over a fixed risk-free return.
High average excess returns and low relative volatility (tracking error) are desirable for active funds. Therefore, the higher the information ratio, the better. It is difficult to say which value is appropriate, as the ratio varies depending on the time period considered. Large positive values ββare generally acceptable.
A negative information ratio means that the average excess return is negative with respect to the numerator. The standard deviation of the denominator is always positive. Therefore, most passive funds have a negative information ratio.
So, can information ratios be used for analysis of index passive funds?
For passive funds, excess returns should be small and negative. The tracking error should be small. Therefore, for passive funds, both the numerator and denominator should be small, resulting in a negative information ratio.
So it’s easy to see that using information ratios for index funds and ETFs is not intuitive. The ratio must be either small or large. To make the ratio smaller (larger), the numerator must be smaller (larger) and the denominator larger (smaller). When both have to be small, as is the case with index funds, the ratio is difficult to assess.
Instead, we simply look for tracking differences. It is defined as the Fund Fund Difference minus the Index Difference for different time periods. Think about the past year, two years, and so on. You can do the same for tracking error and choose funds with consistently low tracking variance and tracking error. We employ this approach in our monthly index fund tracking error screening.
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