Investing can feel overwhelming at times, especially with all the technical terms and figures. To make things simpler, SEBI the regulator for mutual funds in India has introduced ways to help investors compare and assess different mutual fund schemes more effectively. That’s where risk-adjusted returns and the Information Ratio (IR) come into play.
– Similar profits, varying risk exposure
Let’s say both you and a friend invest ₹1,000. You choose a safe, fixed-income option and earn ₹50. Your friend invests in stocks and also makes ₹50. The returns are identical but the difference is in the risk. Your investment was stable, while your friend had to take on much more risk to get the same result.
Mutual funds work in a similar way. Two funds might deliver the same returns, but one could be much riskier than the other. That’s why looking at just the return figure doesn’t give the full picture.
What matters is how those returns were achieved. Risk-adjusted returns help you evaluate how much extra return a fund generated for the amount of risk taken. This is exactly what the information ratio is designed to measure.
– What is Information Ratio?
The information ratio reflects how much a fund has gained over its benchmark and how reliably it has done so over time. It helps investors judge both the level and consistency of a fund’s performance relative to the market.
The Information Ratio (IR) is calculated using this formula:
IR = (Fund return – Benchmark return) ÷ Standard deviation of the excess return
In plain terms, it shows how consistently a fund has outperformed its benchmark, factoring in the amount of risk taken. Risk here means how much the fund’s additional returns compared to the benchmark fluctuate over time. A higher IR indicates that the fund has delivered those extra gains in a more stable, less volatile way.
Here’s how investors typically read IR scores:
IR of 1 or above: A strong sign. The fund has regularly outperformed the benchmark without taking on too much risk.
IR close to 0.5: A fair result. The fund has done reasonably well and managed risk decently.
Negative IR: A red flag. The fund may be taking on risk but not translating that into better performance.
As per SEBI’s latest guidelines, all mutual funds are now required to disclose the information ratios of their equity schemes on their websites. This data is updated daily and presented for different time frames such as 1, 3, 5, and 10 years. The Association of Mutual Funds in India (AMFI) also shares this information in a standardized format to help investors easily compare different funds.
– How can investors make the most of the Information Ratio (IR)?
The IR is most useful when comparing funds within the same category. For instance, it makes sense to compare large-cap funds with other large-cap funds. But using it to compare a large-cap fund with a mid- or small-cap fund which have different risk profiles won’t give meaningful insights.
It’s also smart to look at the IR over multiple time periods. If a fund maintains a high IR across 3, 5, and 10 years, that’s a good sign of consistent, disciplined performance. On the other hand, if the IR keeps fluctuating, it may point to instability or rising risk.
Most importantly, the IR helps cut through the noise of flashy returns that might actually come with higher risks. It gives you a clearer picture of which funds are likely to perform well steadily without too many unpleasant surprises.
– Limitations of the Information Ratio
Like any financial tool, the Information Ratio (IR) isn’t perfect. While it’s useful, relying on it alone for investment decisions can be misleading. It’s always better to look at multiple metrics when evaluating a mutual fund. Here are some key limitations to keep in mind:
1. Only Measures Relative Performance
The IR shows how a fund performs compared to its benchmark but not how well it’s doing in absolute terms. So even if a fund has a high IR, it might still be underwhelming if the benchmark itself is doing poorly.
2. Heavily Benchmark-Dependent
The value of the IR depends on how well the benchmark matches the fund’s investment strategy. If the benchmark isn’t appropriate, the IR can give you a distorted view of how the fund is really performing.
3. Can Be Skewed by Short-Term Swings
Short-term market ups and downs can impact the IR, especially in funds with high tracking error. That means the IR might not reflect the fund’s long-term consistency or true quality.
4. Ignores Other Types of Risk
The IR focuses only on volatility compared to the benchmark. It doesn’t factor in other critical risks like credit risk, liquidity risk, or overall market risk. So, it gives just one piece of the bigger risk picture.
5. Not Very Beginner-Friendly
For someone new to investing, the concept of the Information Ratio along with terms like tracking error and benchmark returns can be hard to grasp. It takes some financial know-how to use this metric effectively.
– Information Ratio vs Sharpe Ratio
The Information Ratio (IR) and Sharpe Ratio both measure risk-adjusted returns, but they serve different purposes. IR evaluates how consistently a portfolio outperforms a benchmark, adjusting for tracking error. In contrast, the Sharpe Ratio compares returns to a risk-free rate and adjusts for total volatility.
IR is useful when comparing active funds to index benchmarks, while the Sharpe Ratio is better for comparing investments with varying risk levels.
– Difference between Information Ratio and Sharpe Ratio
| Criteria | Information Ratio | Sharpe Ratio |
| What it measures | Excess returns relative to a benchmark, adjusted for risk | Excess returns over the risk-free rate, adjusted for total portfolio risk |
| Main purpose | Judges how well a fund manager beats a benchmark consistently | Shows how efficiently a portfolio earns returns for the level of risk taken |
| Formula | (Portfolio Return – Benchmark Return) ÷ Tracking Error | (Portfolio Return – Risk-Free Rate) ÷ Portfolio Standard Deviation |
| Type of risk used | Tracking Error (volatility of returns over the benchmark) | Standard Deviation (overall return volatility) |
| Reference point | Benchmark index like Nifty 50 or Sensex | Risk-free return like Indian Government bond yield |
| How it’s used in India | To compare performance of actively managed funds against market indices | To gauge risk-adjusted performance relative to risk-free alternatives in India |
– Conclusion:
The Information Ratio is a powerful tool for understanding how consistently a mutual fund outperforms its benchmark while managing risk. It adds context to raw return numbers and helps you see beyond short-term spikes or flashy performances. But like any single metric, it shouldn’t be used in isolation. Use it alongside other indicators like the Sharpe Ratio, fund category, and your own goals. The real value lies in using the IR to spot disciplined, steady performers funds that don’t just chase returns, but earn them wisely.
To understand more on the topic as well as to start investments please feel free to contact us:
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E-mail: team@richvikwealth.in
The article is authored by Ms. Ritika Sharma from Team RichVik.