A regular client calls you, concerned that two mid-cap funds have identical tracking errors relative to the benchmark but show vastly different performance histories. You are caught in a classic advisory dilemma where the raw volatility of the fund against its index does not tell the full story of the manager’s skill.
If you rely solely on tracking error, you are only measuring how closely the manager follows the index, but you are completely blind to whether the deviations they take are actually generating value. This is precisely why, as a distributor, you must look at the Information Ratio to determine if the active risk is worth the potential return.
The Information Ratio is effectively the engine behind a manager’s performance consistency. While tracking error tells you the magnitude of the divergence from the benchmark, the Information Ratio tells you the efficiency of that divergence. It is calculated by taking the fund’s active return, which is the difference between the fund return and the benchmark return, and dividing it by the tracking error.
A high Information Ratio implies that for every unit of active risk the manager took, they delivered a significant excess return. It is the definitive metric for discerning between a manager who is simply ‘gambling’ by deviating from the index and one who is ‘skilling’ the portfolio through calculated sector or stock selection.
Consider an HNI client looking to deploy ₹25 lakh across various equity strategies. If you present two funds with an identical tracking error of 4%, but one has an Information Ratio of 0.5 while the other has 1.2, your recommendation becomes data-backed. The second fund is mathematically more efficient at translating active risk into alpha. By focusing on this ratio, you protect the client from selecting funds that take high, uncompensated risks—a common cause of disappointment when market cycles turn.
It shifts the conversation from merely ‘beating the benchmark’ to ‘delivering superior risk-adjusted performance.’
This metric is particularly vital in the context of SIFs and actively managed mutual funds where the investment strategy might be niche. Since SIFs require a minimum investment of ₹10 lakh at the PAN level, the stakes are higher for the investor, and your fiduciary responsibility to guide them toward efficient managers increases. A fund that consistently posts a high Information Ratio provides a compelling narrative for your review meetings, justifying the higher management fees that often accompany active strategies.
Mastering this calculation ensures you remain a consultant who adds value, rather than a mere processor of transaction slips.
Nuance
Check Your Understanding
An equity mutual fund has an active return of 6% and a tracking error of 3%. Another fund in the same category has an active return of 4% and a tracking error of 1.5%. Based on the Information Ratio, which fund is more efficient?
When evaluating a Specialized Investment Fund (SIF) strategy, why should a distributor prioritize the Information Ratio over just looking at historical returns?
This is a companion read for Section 11.8 — Tracking Error from Pass Certification Examination for Mutual Fund - Specialized Investment Fund Distributors by Akhilesh Gururani, available on Amazon Kindle.
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