While choosing a mutual fund, individual investors consider only the historical returns of the scheme which is a risky proposition. Investors should evaluate the risks associated with the mutual fund scheme before investing. One way of measuring the risk is through information ratio which captures the stock selection skill-set of the fund manager. Let us understand the same in detail.
Routine check is mandatory
A routine check on your mutual funds is very important. It helps you to understand where the fund is heading. The general mechanics is comparing the performance of your fund with that of the benchmark index which could be Sensex or Nifty. But diligent investors should go one step further and check it in the context of the risk taken to deliver the return.
Information ratio (IR) is computed by dividing the active return of the fund divided by its tracking error. Active return is the difference between the fund s return and that of its benchmark index, and tracking error is the standard deviation of the active return. IR measures the fund s performance relative to its benchmark and adjusts it for the volatility in the dispersion between the two. It is also known as appraisal ratio.
The information ratio is the higher order version of Sharpe ratio. Sharpe ratio is the excess return of an asset over the return of a risk-free asset divided by the variability or standard deviation of returns. But, the information ratio is the active return to the most relevant benchmark index divided by the standard deviation of the active return or tracking error. It is basically used to measure the performance of the mutual funds managers active performance.
Essentially, the information ratio tells an investor how much excess return is generated from the amount of excess risk taken relative to the benchmark. This ratio test the consistency of a fund manager as it determines whether a manager has beaten the benchmark by a large margin in a few months or by small margins every month.
For a given level of risk taken, a higher active return will lead to a higher information ratio which indicates the consistency of a manager in delivering superior returns. The higher the information ratio, the better is the performance of the fund manager. Information ratio is extremely useful in comparing a group of funds with similar management styles.
Generally, information ratio is reported in the fact sheet of the mutual funds. If the information ratio of a mutual fund is negative, it indicates that the mutual fund manager was unable to produce any excess returns at all. An information ratio of less than 0.4 means that the mutual fund could not produce excess returns for a sufficiently long time and the fund may not be a good investment. If the information ratio is between 0.4 and 0.6, it is considered to be a good investment and an information ratio between 0.61 and 1 is considered as a great investment.
To conclude, there are many ways that an investor can measure the performance of a mutual fund. The simplest measure of performance is return on investment. But, the simplest view was not able to make a direct comparison between the risk and return for different funds. Investors should check the information ratio before investing in any mutual fund and if the information ratio is below 0.4, better avoid investing in those funds.
The writer is a professor of finance and accounting, IIM Tiruchirappalli