When it comes to picking flowers, we all know intuitively how to choose our favorites by its color, smell, texture and appearance. However, do you know how to pick the best investment managers? How does your mutual fund really stack up? There are great resources at Morningstar (www.morningstar.com), but I’d like to introduce you to the Information Ratio.
What is the Information Ratio?
Active return alone is not sufficient in measuring the manager’s performance over a series of measurement periods. For example, if you have Manager A who earns a constant 0.5% active return over each of the last four quarters and Manager B who earned active returns of 8%, 5%, -3%, and -8% over the same four quarters. The average active returns for Manager A and Manager B are both 0.5%, but Manager B experienced much more volatility or less consistency than Manager A.
A better measure of a manager’s ability to consistently generate active returns, we utilize the Information Ratio. We standardize average active return by dividing it by its standard deviation. The Information Ratio equals the portfolio’s average active return divided by the portfolio’s tracking risks.
The higher the Information Ratio, the more active return the manager earned per unit of active risk. The Information Ratio is very similar to the Sharpe Ratio. Their numerators are similar because they both compare the average portfolio return to a benchmark. The Sharpe Ratio uses the risk-free rate as the benchmark and the Information Ratio uses a portfolio benchmark return like the S&P 500, Dow Jones Index or one that best matches the investment style of the managed portfolio. In the denominator, both uses standard deviation to measure dispersion/variability. The Sharpe Ratio uses the standard deviation of portfolio returns over the measurement period, while the Information Ratio uses the standard deviation of the active return over the measurement period.
How can you compute the Information Ratio?
1) Download the historical monthly price of your mutual fund from websites like Yahoo.
Step A: Go to www.finance.yahoo.com.
Step B: Enter Ticker Symbol.
Step C: Click Historical Prices (see example in red below).
Step D: Click on Monthly then Get Prices (see example in red below).
Step E: Click Download to Spreadsheet (see example in red below).
Step F: Click Save File and Ok (see example in red below).
Step G: Open Excel File to view data.
NOTE: Some stocks/mutual funds have dividends like OAK.
2) Download the historical monthly price of your benchmark like SPY for S&P 500 from websites like Yahoo.
Repeat Steps A thru G for benchmark like SPY, QQQ, DIA, etc.
3) Calculate monthly returns for mutual fund and benchmark ((Current Month Price + Dividends)/ Previous Month Price – 1).
4) Calculate mutual fund return less benchmark return.
5) Calculate average monthly returns for both mutual fund and benchmark.
6) Calculate standard deviation of mutual fund return less benchmark.
7) Information Ration = (Average Monthly Mutual Fund Return – Average Monthly Benchmark Return) / (Standard Deviation of Mutual Fund Return less Benchmark).
Words are not always enough, so I provided samples. Attached is an Excel file with calculations for Berkshire Hathaway Inc. (BRK-B) and Oaktree Capital Group, LLC (OAK) Information Ratios (click here for file: http://www.trueinvestmentresearch.com/2014/07/09/information-ratio-measure-managers-performance/).
How do you use this analysis? You will notice Berkshire Hathaway Inc. has a higher Information Ratio than Oaktree Capital Group, LLC from my Excel spreadsheet analysis. As a result, if you had to choose between the two investment managers at Berkshire or Oaktree you would conclude that Berkshire has a history of generating more “Alpha.”
Investopedia define Alpha as “A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.”
If you learn to use the Information Ratio, this tool will help you pick some of the best investment managers for your portfolio and hopefully will help you generate more Alpha!