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Ratios



Information Ratio
So called because it assesses the degree to which a manager uses skill and knowledge to enhance returns, this is a versatile and useful risk-adjusted measure of actively-managed fund performance. It is calculated by deducting the returns of the fund's benchmark from the fund's overall returns, then dividing the result by its Tracking Error (which is a measure of the volatility of those excess returns). In this way, we arrive at the value, per unit of extra risk assumed, that the manager's decisions have added to what the market would have delivered anyway.
The higher the Information Ratio the better. It is generally considered that a figure of 0.5 reflects a good performance, 0.75 very good, and 1.00 outstanding. This is particularly useful when comparing a group of funds with similar management styles and asset allocation policies. If two funds have near-identical Alphas, the higher Information Ratio identifies the manager who has been more skilful in betting on stock-picks that deviated from the benchmark or index, while the lower denotes gains that have more to do with market movements than active management . However, this comes both with a caveat, and a means of using it creatively. As ever, the R-squared correlation between the fund and its benchmark must be strong if any discrete reliance is to be placed upon the Information Ratio. Its versatility, though, comes from the point that 'added value' does not necessarily mean value added to the fund's own benchmark. Analysts can decide which benchmark or index they wish the fund to outperform, and run the statistics accordingly.
Worked Example: Information Ratio & Tracking Error
If Tracking Error (TE) is an indicator of how active a fund manager's investment activity is, Information Ratio (IR) will measure the extent to which the manager's investment-picking skill has been rewarded. In the following table we can examine two funds that have raised TEs, and which have generated positive IR.

Table 11. Ratios table over 36 months (from 31 Aug 2002 to 31 Aug 2005) against benchmark "UT UK Smaller Companies" (risk free rate at 3.5%) from Unit Trust/OEIC universe
Name Alpha Beta Sharpe Info Ratio Tracking Error
Aberforth UK Small Cos TR 4.54 0.85 1.61 0.36 4.02
Barclays Smaller Cos TR -4.55 1.11 0.94 -0.57 4.38
Capita Canlife UK Smaller Cos TR -1.49 1.06 1.09 -0.07 6.6
Framlington UK Smaller Cos TR 5.71 1.21 1.68 1.6 6.04
Sector: UT UK Smaller Cos TR 0 1 1.3 0 0

Aberforth's TE indicates a measure of active management, while its IR records that this has been rewarded to a reasonable, if unremarkable, extent. Framlington has a Sharpe Ratio in the same range, but its TE is half as much again as Aberforth's. Some investors could feel nervous about this level of volatility in the fund's investment activity, but the IR of 1.6 is evidence of the outstanding performance that has resulted from venturing away from the sector's composition.
This is further illustrated in the next table where, over any appreciable length of time, Framlington has substantially outperformed its sector-mates.

Table 12. Total return standard performance table from Unit Trust/OEIC universe
Name 1m 3m 6m 1y 3y
Aberforth UK Small Cos TR 2.57 6.18 6.7 29.64 102.28
Barclays Smaller Cos TR 2.2 6.36 2.97 24.92 85.34
Capita Canlife UK Smaller Cos TR 6.39 15.83 5.21 22.7 103.01
Framlington UK Smaller Cos TR 5.31 13.28 7.28 49.43 174.93
Sector: UT UK Smaller Cos TR 3.14 9.17 4.69 29.06 100.19

The final point about active management interventions is clear from the Barclays and Capita funds. Their TEs are marginally higher than the other funds in this example, but the managers' bets on more volatile stocks are not paying off, and we can see this in the negative IRs.
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