For anyone who is either investing or evaluating investment managers, the information ratio is a powerful key to successfully understanding manager performance. It’s powerful because it gets to the heart of measuring an investment manager’s skill. It does not simply ask, “Did the manager hit a home run?” but rather “How many runs did the manager hit from the swings taken?” The information ratio, therefore, allows investors to quantify risk-adjusted returns, and thus compare managers who are taking different amounts of risk and generating different amounts of return.

There are three important things to know about information ratio:

  1. It is a powerful tool for thinking about successful investing,
  2. It is a reasonably simple concept once investors get their arms around it, and
  3. The odds are pretty good that investors—even if they don’t know the exact definition—do care about what it measures.

Back to basics: Manager returns ≠ manager skill

Let’s first consider a fictional situation to better understand the relationship between investment returns on the one hand and risk and skill on the other. Two investment managers sit down at a roulette table in a smoke-filled casino. Both are in elegant tuxedoes. One is wearing an eyepatch, while the other has a prominent scar down her right cheek. The casino is someplace glamorous like Monte Carlo, there is a powerful storm outside, and every few minutes the windows light up as lightning scorches across the night sky. To keep things really simple: the two managers (let’s call them Scar and Eyepatch) are playing on a French roulette wheel (36:1 odds), and all bets pay the same expected value. Scar places $1 on one of the 36 numbers. This bet has 36:1 odds, a 35:1 payout, and an expected value of -2.7cents, or -2.7% (that’s the house’s edge – we’ll call them transaction costs). Eyepatch places $1 on red. That bet has 1.06:1 odds, a 1:1 payout, and an expected value of -2.7cents, or -2.7%.

The roulette wheel spins. Outside, lightning crackles. The ball settles on… a red number… the exact number that Scar chose! Both managers won their respective bets. In terms of return performance, both our managers did very well by the standards of most asset classes in 2016. Eyepatch doubled his money, and Scar earned a whopping 3600%. Assets will no doubt come pouring in to both of their respective funds.

But how would we compare each manager’s skill? We can safely assume that both managers possess the same level of skill as anyone does when it comes to roulette: none. This is where the simplicity of the example is instructive. Scar placed a very risky bet—one that offered small odds and a correspondingly large payoff, while Eyepatch placed a comparatively less risky bet—with larger odds and a correspondingly smaller payoff. Roulette reminds us of a basic truth: the fact that Scar made 36 times more money than Eyepatch on this spin of the roulette wheel does not make her a more skilled player.

Risk-adjusted returns

Let’s now take this example from the roulette wheel to the world of investing. Scar invests in a bond issued by a very large, well-established, profitable, strongly capitalized, highly rated company with very little debt. Eyepatch invests in a bond issued by a small, speculative, unprofitable, thinly capitalized, low-rated company with lots of debt.   But this is where it gets complicated: the first bond pays a 2.5% yield whereas the second one pays a 10% yield. The first bond is less risky and offers less return, while the second one is more risky and offers more return. Which one is a more attractive bond? That depends on many different things—risk appetite, investment objectives, financial forecasts, for example—but if we want to compare two investments with different risks and returns, it’s most helpful to compare them in terms of units of return per unit of risk. Looking through the lens of risk-adjusted returns instead of simple total returns provides investors with the discipline to see through a 36:1 bet at the roulette table, and prevents confusing skill with luck.

Quantifying manager skill by measuring risk-adjusted returns

An information ratio allows investors to quantify risk-adjusted returns, and thus compare managers who are taking different amounts of risk and generating different amounts of return. It is a disciplined and consistent measure of how much return a manager is generating per unit of risk.

Unlike the Sharpe ratio, which uses Treasury bills (or the risk-free rate) as the yardstick, an information ratio is a more generalized formulation that can be calculated relative to any benchmark. An information ratio measures how well a portfolio did compared with its benchmark (its mean excess return) divided by how volatile those returns were (using the standard deviation, a measure of volatility).

At the simplest level, this calculation is just “return, divided by risk.” One layer deeper, the calculation is “return versus a benchmark, divided by risk versus a benchmark.” The numerator looks at excess returns, so the return of a portfolio minus the return of a benchmark (for example, the return of a bond manager vs. the Barclays Aggregate Bond Index, or of an equity manager versus the S&P500). The denominator looks at risk. In this case, risk is defined as the variability of those excess returns, calculated as the standard deviation of the excess returns (this is sometimes also called tracking error or tracking risk). The information ratio equals “by how much on average does a manager beat (the benchmark)”, divided by “how much do those beats (outperformance) bounce around.”

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Four implications of that definition:

  1. The information ratio of a benchmark is zero (because there is no excess return when comparing a benchmark with itself).
  2. If a manager does not beat the index, that manager will have a negative information ratio (the numerator will be negative).
  3. Managers who generate greater excess returns with lower volatility will have higher information ratios than those who generate lower excess returns with higher volatility.
  4. Managers can potentially generate a higher information ratio by increasing excess returns for a given amount of risk (standard deviation of those excess returns). Alternatively, they may generate a higher information ratio by decreasing risk for a given amount of excess return.

The information ratio is powerful because it gets to the heart of measuring an investment manager’s skill. It does not ask, “Did you swing big and get lucky?” but rather “How many runs did you hit versus how many swings you took?” It therefore allows for a consistent and disciplined comparison of the risk-reward tradeoff that investment managers are making.

Alignment with investment objectives

A lot of investors don’t know what an information ratio is.  Some might tune out as soon as they hear the words “standard deviation.” In our experience however, investors do think about it and express it in a variety of different ways. Most investors are intuitively interested in investing with managers who generate high risk-adjusted returns. This can be especially true in fixed-income. Our team manages investment-grade fixed-income strategies, and we always ask our investors: “What is the mission or the investment objective of your portfolio?” In fixed income, that mission is rarely one dimensional, and it is typically well balanced between risk and return. Most often, investors do not simply want to maximize their returns at all costs. They do not invest in investment-grade bonds with the expectation that they will double in a year like a hot biotech or go-go tech stock, but they do expect investment-grade bonds to provide diversification in market downturns, performance that is uncorrelated to equities, and a high degree of capital preservation. On the other hand, investors do not invest in this asset class only as an umbrella on a rainy day but expect investment-grade bonds to generate reliable income and capital appreciation. Put another way, investors who may not know or care to know what an information ratio is can certainly appreciate a good information ratio from their manager.

Today we have a guest post from David Klug, CFA, portfolio specialist with the Montgomery Fixed-Income team, a subadvisor of the Wells Fargo Core Bond Fund.

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