When investors evaluate a Portfolio Management Service (PMS), they often focus on returns. A PMS that delivered 25% annual returns naturally appears more attractive than one that generated 18%. But is a higher return always better?
Not necessarily.
Professional investors know that how those returns were achieved matters just as much as the returns themselves. This is where the Information Ratio (IR) becomes one of the most insightful performance metrics.
Beyond Returns: Measuring Skill, Not Luck
Imagine two PMS strategies.
- PMS A outperformed its benchmark by 6% every year with remarkable consistency.
- PMS B also beat the benchmark by 6% on average, but its performance fluctuated wildly—sometimes outperforming by 15%, other times underperforming by 8%.
While both generated the same average excess return, most investors would prefer PMS A because of its consistency.
The Information Ratio captures exactly this difference.
What is the Information Ratio?
The Information Ratio measures how consistently a portfolio manager generates returns above a chosen benchmark.
It is calculated as:
Information Ratio = Excess Return ÷ Tracking Error
Where:
- Excess Return = PMS Return − Benchmark Return
- Tracking Error = Volatility of the excess returns
In simple words, the Information Ratio answers one important question:
How much additional return did the fund manager generate for every unit of active risk taken?
Why Does It Matter?
A portfolio manager can outperform the market simply by taking aggressive bets.
However, consistently outperforming the benchmark without excessive fluctuations demonstrates genuine investment skill.
A higher Information Ratio generally indicates:
- Better stock selection
- More disciplined portfolio construction
- Consistent alpha generation
- Efficient risk management
Rather than rewarding occasional lucky outcomes, the Information Ratio rewards repeatable performance.
A Simple Illustration:
Consider two PMS strategies benchmarked against the Nifty 500.
Metric PMS A PMS B
Annual Return 20% 20%
Benchmark Return 15% 15%
Excess Return 5% 5%
Tracking Error 4% 10%
Information Ratio 1.25 (PMS A) 0.50 (PMS B)
Although both managers generated the same excess return, PMS A delivered it much more consistently.
That higher Information Ratio suggests investors were compensated more efficiently for the active risk taken.
What is Considered a Good Information Ratio?
While there is no universal threshold, industry practitioners often interpret the metric as follows:
- Below 0.25: Limited evidence of consistent outperformance
- 0.25–0.50: Moderate active management skill
- 0.50–0.75: Strong performance consistency
- Above 0.75: Excellent active management
- Above 1.00: Exceptional and relatively rare over long periods
It's important to evaluate the Information Ratio over longer time horizons—typically three to five years or more—to avoid being misled by short-term market conditions.
Information Ratio vs Sharpe Ratio
These two ratios are often confused, but they answer different questions.
Sharpe Ratio asks:
"How much return was generated for every unit of total risk?"
It compares portfolio returns with the risk-free rate and considers overall portfolio volatility.
Information Ratio asks:
"How efficiently did the manager outperform the benchmark?"
It focuses solely on active management decisions and benchmark-relative performance.
For PMS investors, the Information Ratio is often the more relevant metric because PMS managers are expected to actively outperform an index, not merely deliver attractive absolute returns.
One Metric Isn't Enough
While the Information Ratio is powerful, it should never be viewed in isolation.
A comprehensive PMS evaluation should also consider:
- Investment philosophy
- Portfolio concentration
- Drawdown history
- Risk-adjusted returns
- Portfolio turnover
- Consistency across market cycles
- Tax efficiency
- Fund manager tenure
Numbers tell part of the story; the investment process tells the rest.
The Bottom Line
- The best portfolio managers aren't necessarily those who deliver the highest returns in a single year. They are the ones who consistently create value above their benchmark while maintaining disciplined risk management.
- The Information Ratio helps investors distinguish sustainable investment skill from temporary good fortune.
When comparing PMS strategies, don't just ask:
"How much did the portfolio return?"
Also ask:
"How consistently did it outperform its benchmark?"
That answer often reveals far more about the quality of the portfolio manager than returns alone.