Intermediate

When evaluating the performance of mutual funds, investors often look beyond simple return figures. One crucial metric used in performance analysis is the Information Ratio (IR). IR helps measure how well a fund manager generates returns relative to a benchmark, considering the consistency of those returns. Let us understand in detail what IR is, how it is calculated, and how to interpret it with different scenarios.

What is the Information Ratio (IR)?
The Information Ratio (IR) is a financial metric used to evaluate the risk-adjusted return of a mutual fund. It tells investors whether a fund manager is delivering returns higher than the benchmark and how consistently they are doing so. A higher IR indicates better fund performance with stable excess returns, while a lower IR suggests high volatility or underperformance compared to the benchmark.

Formula for Calculating Information Ratio (IR)
The Information Ratio (IR) is calculated as:
IR Formula:
IR= Portfolio Returns−Benchmark Returns / Standard Deviation of Excess Returns

Explanation of Terms:
• Portfolio Rate of Returns: The return generated by the mutual fund portfolio over a given period.

• Benchmark Rate of Returns: The return of a benchmark index (e.g., NIFTY 50, BSE 30) against which the fund's performance is measured.

• Excess Return: The difference between the portfolio’s return and the benchmark’s return:

• Standard Deviation of Excess Return: A measure of the volatility of excess returns over time. It shows how consistently the fund generates excess returns. It is normally calculated on the basis of daily excess return values.

Methodology for Calculating IR in Equity-Oriented Mutual Fund Schemes
To maintain uniformity across different mutual funds, the calculation of IR for equity-oriented mutual funds follows these guidelines:
1. Benchmark Selection:
• The Tier 1 benchmark currently used by equity-oriented mutual funds should be considered. To make it easy to understand, A Tier 1 benchmark is a widely recognized and trusted market index used to evaluate the performance of mutual funds, particularly in the equity-oriented category. It serves as a standard reference point to compare how well a fund is performing relative to the broader market.
• Common benchmarks include NIFTY 50, BSE Sensex, BSE 30, etc.

2. Calculating Volatility/Standard Deviation:
• The standard deviation of excess returns should be computed using daily return values.
• Standard deviation measures the fluctuation in excess returns over time.

3. Daily Portfolio Return Calculation:
• The portfolio returns should be calculated using the arithmetic function, which means summing up daily returns and averaging them over the period.
By following this methodology, fund managers and analysts ensure consistent and accurate calculation of IR across mutual funds.

Interpretation of Information Ratio with Examples
Scenario 1: High IR (IR > 0.5)
• Fund A has an IR of 0.8, meaning it consistently beats the benchmark with low volatility.
• This suggests the fund manager has strong stock-picking skills and generates excess returns in a stable manner.
• Investors prefer funds with a high IR as they indicate better risk-adjusted performance.

Scenario 2: Low IR (0 < IR < 0.5)
• Fund B has an IR of 0.3, meaning it beats the benchmark occasionally but with significant volatility.
• This indicates that while the fund has positive excess returns, they are inconsistent.
• Investors should assess whether the volatility is acceptable compared to potential returns.

Scenario 3: Negative IR (IR < 0)
• Fund C has an IR of -0.2, meaning it consistently underperforms the benchmark.
• A negative IR indicates that the fund manager is not adding value, and the investment strategy may be ineffective.
• Investors should reconsider investing in such funds unless they anticipate future improvements.

Why is IR Important for Investors?
1. Measures Fund Manager’s Skill:
• A high IR suggests a fund manager’s ability to generate excess returns consistently.
2. Helps Compare Funds:
• Investors can use IR to compare different mutual funds with the same benchmark.
3. Considers Risk and Return Together:
• Unlike absolute return figures, IR accounts for volatility, providing a better measure of risk-adjusted performance.

The Information Ratio (IR) is a valuable tool for investors analysing mutual funds. It helps determine whether a fund’s excess returns justify the associated risk. By following a standardized calculation methodology, IR provides a consistent measure across different funds, making it easier for investors to compare and choose the best-performing funds.

For investors looking for stable and high-performing mutual funds, a higher IR is preferable. However, it is essential to consider IR along with other financial metrics before making investment decisions.

*For detailed understanding regarding Information Ratio, click on the link amfiindia.com/information-ratio