Information Ratio

Course: Investment Planning
Lesson 14: Evaluation Portfolio Performance

Student Question:

Hello,

In calculating Information Ratio, why do we need the denominator to be Standard Deviation of the difference in portfolio and index returns?  This is unlike the Sharpe Ratio, where the denominator is Standard Deviation of the Portfolio. Doesn’t the Standard Deviation of the Portfolio indicate systematic and non-systematic risk? And shouldn’t that just suffice?

Thank you,

Meera


Instructor Response:

Hi Meera,

Thank you for your question.

Information Ratio

You understand Sharpe perfectly.  Unlike Sharpe, the Information Ratio measures the standard deviation of the excess returns (if any) in a portfolio.  An excess return is return in excess of the returned expected at a given level of investment risk.  From the lesson content, “The numerator can be seen as the average excess return, and the numerator the standard deviation of excess return…The higher the Information Ratio, the higher the excess return of the selected fund given, the amount of risk involved, and the better the fund manager.”

The Sharpe Ratio measures only risk-adjusted return, not excess return. 

Onward and Upward,

Bruce