Information Ratio & Risk Adjusted Ratios
Information Ratio
The Information Ratio standardizes tracking error across asset managers by dividing the excess return over risk free rate by tracking error. A high information ratio indicates the asset manager is delivering superior returns over the risk-free rate with a low tracking error. This ratio helps in understanding various index funds in mutual funds keeping the benchmark index constant. Its important to understand that the risk-free rate will be lower among advanced countries compared to emerging countries. A more developed market will have a more liquid and supplicated capital markets with lower cost of raising funds. Among peers within similar basket of countries with economic development, a lower risk-free rate signifies lower cost of borrowing for corporates. In the US, yields of T bills are a barometer of risk-free rate while in India yield of a 10 year could be taken as risk free rate. The yield between developed country example a 10 yield on US government bond and yield of similar 10 year both of other countries will signify the risk premium linked to the sovereign risk of that particular country. This concept is discussed in the Introduction to Investment Valuation online course.
Risk Adjusted Return
Usually, the widely used risk adjusted return is the Sharpe ratio. In the Sharpe Ratio, expected return over the risk-free rate is divided by the standard deviation of the asset manager. Standard Deviation or Variance, which is the square of standard deviation, is an adequate barometer for quantifying risk. The Sharpe Ratio measures both the upside and downside volatility of the asset class. The Sortino Ratio captures only the downside risk. This means only the negative standard deviation of the asset manager is calculated. Treynor Ratio is another excellent measure to capture the risk of the asset manager with a benchmark index designated as beta. Beta can be termed as the covariance of the asset manager with the benchmark index. A beta of 1 means the asset manager or stock is expected to give a 100 percent return if the benchmark index goes up by 100 percent, or fall by 100 percent if the benchmark index falls by 100 percent. Let’s consider the Indian stock exchange NSE. Stocks in NSE with betas greater than 1 are called high beta stocks. This means they are expected to deliver higher returns compared to their benchmark. This variable is captured through Jensen’s Alpha. Stocks with beta less than 1 are low beta stocks, which means they are less risky than high beta stocks and therefore their expected return will be less than higher beta stocks, keeping with the concept of risk and return. Usually, high beta stocks are high growth volatile stocks with higher leverage ratios more tuned to economic cycles example technology, while low beta stocks could be in well established companies for example in FMCG (Fast Moving Consumer Goods), for example Procter & Gamble and Hindustan Unilever Limited. (Keeping other factors constant) Procter & Gamble has a beta of 0.44, Hindustan Unilever Limited has a beta of 0.09. Alphabet has a beta higher than 1 (beta 1.06) while Microsoft less than 1 (beta 0.9) though both are top global technology companies. Beta information shared by Yahoo Finance.
Why is Alphabet’s beta more than Microsoft ? The answer lies in the business’ model of Alphabet.