The Sharpe Ratio and the Information Ratio

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The Sharpe Ratio and the Information Ratio

Sharpe Ratio and Information Ratio used to determine the risk-adjusted return of an investment portfolio.

Sharpe Ratio

The Sharpe Ratio introduced a method of assessing manager performance relative to risk taken. Sharpe Ratio centres on the use of a RFR, this places all mangers on a level playing field regardless of style.

(Expected Portfolio Return – RFR) / Portfolio Standard Deviation

Hypothetically, investors should always be able to invest government bonds and obtain the RFR. The sharpe ratio determines the expected realized return over that minimum. Within the risk-reward framework of portfolio theory, higher risk investment should produce high returns. As a result, a high Sharpe ratio indicates superior risk adjusted performance.

Sharpe ratio measures a portfolio’s added value relative to its total risk. (A portfolio of risk free assets or one with an excess return of zero would have a Sharpe ratio of zero.) Sharpe ratio was based on portfolio theory, it is designed to be applied to investment strategies that have normal expected return distributions, it is not suitable for measuring investments that are expected to have asymmetric returns.

Information Ratio

(Portfolio Return – Benchmark Return) / Tracking Error or Active Return/Active Risk

(Portfolio Return – Benchmark Return) referred to as the active return. The IR uses the SD of active returns as a measure of risk instead of the SD of the portfolio.

It measures the manager’s excess return over an appropriate benchmark relative to the SD of those excess returns. By computing risk on a relative return basis, the IR effectively eliminates market risk, showing only risk taken from active management. Therefore, in one simple number, the IR shows how a manger has performed per unit of active risk taken.

Shortcomings of IR

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