Tipping Point

What is information ratio of a mutual fund?

It measures how consistent a fund’s performance has been. In the numerator of this ratio, the return of the index is subtracted from the fund’s return, thereby getting a measure of the excess return that it has generated. 

In the denominator is the tracking error, which is the standard deviation of the difference between the return of the portfolio and the return of the index. 

How can investors use it?

Higher the ratio, greater is the fund’s consistency. The latter is desirable because it is easier for investors to stick to funds that beat their index year after year. Investors find it more difficult to stick to a fund whose returns come in spurts, that is, it does very well one year but underperforms for the next few years.