Is beating the benchmark enough? What the information ratio reveals

Economic Times

20-05-2025

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Q. Let's start with the basics—what exactly is the Information Ratio?
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Q. How do you see the IR reshaping the way investors assess fund managers, especially in an era of passive investing?
Q. How is Information Ratio different from other ratios?
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Q. What's the ideal time frame to evaluate the Information Ratio?
Q. I noticed that multicap and contra funds often show a higher Information Ratio compared to large-cap or mid-cap funds over 3–5 years. Why is that?
Q. How should investors use Information Ratio in conjunction with other metrics like Alpha, Beta, or Sharpe Ratio when selecting funds?
Information Ratio shows how efficiently a fund manager has beaten the benchmark considering the risk taken.
Alpha tells you how much excess return the fund generated.
Beta indicates how sensitive the fund is to market movements—i.e., how volatile it is compared to the benchmark.
Sharpe Ratio assesses return per unit of total risk, compared to a risk-free asset.
Sortino Ratio focuses only on downside risk.
Q. How can one interpret whether an Information Ratio is good or not?
Q. What are some limitations of the Information Ratio? Are there risks to over-relying on it?
Q. Lastly, SEBI is pushing for greater fund disclosures and transparency. Should the Information Ratio be highlighted more prominently in fact sheets?
Excerpts:The Information Ratio (IR) is a performance metric that measures a fund manager's ability to generate excess returns over a benchmark, adjusted for the volatility of those excess returns.It shows how effectively a manager delivers better risk-adjusted returns compared to the benchmark.A higher IR indicates more consistent and efficient outperformance, while a lower IR suggests the fund is underperforming relative to its benchmark.Let me give you a comparison: Suppose two large-cap fund managers both deliver a 15% return, beating their 12% benchmark by 3%. Now, if one of them took less risk than the other to achieve this, the Information Ratio will reflect that. The fund manager with the higher Information Ratio would be the preferred choice because he delivered the same return with less risk.This ratio highlights both consistency and efficiency in return generation.Great question. There are two aspects here. First, should investors choose active or passive fund management?When we analysed mutual fund performance over the past five years—across categories like large-cap, flexi-cap, multi-cap, contra, etc.—we found that 60% to 100% of active funds beat the Nifty, and around 70% beat their own benchmarks, except in the large-cap category.So yes, if you choose the right fund, active strategies still offer superior excess returns. Passive funds can't outperform the benchmark—they just mirror it.Secondly, within active strategies, the Information Ratio helps you evaluate the quality of excess return. It allows you to choose fund managers who are not only outperforming but doing so with less risk. That's where this metric really becomes relevant.Most investors use the Sharpe Ratio, which compares a fund's return to a risk-free rate like a 6.5% government bond, adjusted for volatility.But the Information Ratio compares the fund's return to its own benchmark, not to a risk-free asset. That makes it more relevant for mutual funds, because we're evaluating whether the manager added value over what the benchmark would have given.So, while Sharpe is useful, the Information Ratio gives a truer picture of a fund manager's active performance.Time frame is very important. Looking at short-term data can mislead you due to market noise and volatility. On the other hand, a very long-term period like 10 years might not reflect the current fund strategy or manager, as those could have changed.The ideal period is between three to five years. This allows you to evaluate consistent performance while accounting for a reasonably stable strategy and risk profile.Good observation. It's because of investment flexibility.In large-cap funds, 80% of the money must go to the top 100 stocks, leaving little room for creativity or deviation from the benchmark. That limits the potential to generate alpha or excess return.But in multicap, smallcap, flexicap, or contra funds, fund managers can explore beyond the benchmark and use different strategies. That freedom leads to higher alpha, and therefore, a better Information Ratio.You should never rely on any one ratio in isolation.The right approach is to combine all these and assess a fund from multiple angles—consistency, volatility, downside protection, and benchmark-beating ability.You don't need to calculate it yourself—it's already available in the fund fact sheets. You can simply compare the Information Ratio of a fund to the category average.For instance, in the focused fund category, ICICI Prudential Focused Fund has an Information Ratio of 0.9, while the category average is 0.07—a clear indication of superior risk-adjusted performance.In the smallcap space, Invesco India Smallcap Fund has a ratio of 0.5, compared to a 0.1 category average.So yes, the more positive the Information Ratio, the better. It means the fund manager is taking less risk for every unit of extra return.Absolutely. It's just one part of the puzzle.Choosing the right fund starts with knowing your market cap allocation, then shortlisting funds that consistently beat benchmarks, and only then applying tools like the Information Ratio.You can't make a decision solely based on this metric. A fund might have a good Information Ratio today but not fit your overall strategy or allocation. So, use it as a filter, not the final decision-maker.Definitely. Fact sheets are already loaded with data, but unless key metrics like the Information Ratio are better communicated and explained, investors won't benefit.If more people understand and look at the Information Ratio, they can hold their advisors accountable and make more informed, risk-conscious decisions.So yes, SEBI should definitely promote awareness and ensure standardized, visible reporting of such metrics.