Information Ratio in Mutual Funds: A Key to Better Returns
When investing in mutual funds, most people look at past returns or compare funds against a benchmark index. While these are helpful, they don’t tell the whole story. A fund may outperform the market, but how efficiently does it generate that extra return? That’s where the Information Ratio (IR) comes in. The Information Ratio is an important metric that helps investors evaluate how well a fund manager is delivering excess returns relative to the risk taken. In a circular issued on 17 January 2025, SEBI mandated the daily disclosure of the Information Ratio (IR) for equity-oriented mutual fund schemes. In this article delight, we’ll break down what the Information Ratio is, why it matters for mutual fund investors, and how you can use it to make smarter investment decisions.
What is the information ratio?
The Information Ratio (IR) is a quantitative measure used to evaluate the performance of an investment portfolio compared to a benchmark index, factoring in the volatility of the returns. It answers the question: Is the fund manager good at generating more return than the benchmark (like Nifty or Sensex) without taking unnecessary risks?
Why compare risk and returns?
Imagine you and a friend invest Rs 5,000 each. You invest in a fixed deposit and earn Rs 500, while your friend invests in stocks and earns Rs 500 too. Same return, right? But you took no risk, and your friend did. Similarly, mutual funds can generate similar returns, but some take more risk than others. Risk-adjusted returns help measure how much “extra return” a fund manager generates for the risk taken.
The formula for Calculating the Information Ratio
IR = (Fund’s return — Benchmark’s return) / Risk (Volatility of excess returns)
In simple words:
- Fund’s return: How much money the fund made.
- Benchmark’s return: How much money the benchmark index made (e.g., Sensex).
- Risk: Fluctuations in the fund’s performance compared to the benchmark. Risk can be calculated as the standard deviation of a security or portfolio returns from the returns of a benchmark (tracking error).
Example: Calculating the Information Ratio in Mutual Funds
Let’s say you’re evaluating a mutual fund’s performance over the past year. You have the following data:
Mutual Fund Return: 14%
Benchmark Index Return: 10%
Tracking Error (Standard Deviation of Excess Returns): 3%
Now, using the above formula IR comes to be 1.33 , which is considered excellent because it indicates the fund manager has generated 1.33 units of excess return for every unit of risk taken. This suggests consistent outperformance relative to the benchmark.
If another mutual fund had an IR of 0.5, it would mean that while it outperformed the benchmark, it wasn’t as efficient in managing risk as the first fund.
How does the Information ratio in Mutual funds help you?
A higher information ratio means the fund manager is generating better returns for the risk they’re taking.
For example:
- A fund with an IR of 0.5 means the fund manager is generating decent returns for the risk taken.
- An IR of 1 or higher is exceptional — consistent outperformance with controlled risk.
- A negative IR means the fund is lagging behind the benchmark.
Key limitations of the Information Ratio (IR)
- Ignores Absolute Returns – A fund with low overall returns can still have a high IR, making it misleading if considered in isolation.
- Sensitive to Tracking Error – If a fund has low volatility, even slight fluctuations in excess returns can cause IR to swing significantly.
- Not Suitable for All Fund Types – IR works best for actively managed funds but may not be as useful for index funds or funds with passive strategies.
Final Takeaway | Information Ratio in Mutual Funds
By factoring in both excess returns and risk, Information Ratio in Mutual Funds helps investors identify fund managers who consistently add value. However, like any metric, IR should not be used in isolation—it works best when combined with other indicators like the Expense Ratio, Alpha, and Sortino Ratio. When choosing mutual funds, don’t just chase high returns, look for funds with a strong, consistent Information Ratio to ensure you’re investing wisely.
Related news article : SEBI mandates mutual funds to disclose information ratio for risk-adjusted returns sebi-mandates-mutual-funds-to-disclose-information-ratio-for-risk-adjusted-returns-explained-19542250.htm/amp
Read also : The 7-5-3-1 Rule That Every SIP Investor Should Follow https://thebrightdelights.com/the-7-5-3-1-rule-that-every-sip-investor-should-follow/