In 2023, VNINDEX rallied 12.2%. As a smart beta strategy on the equity market, achieving a return below this benchmark should be considered a failure. It’s because it falls short of the passive investing strategy. Surprisingly, under Sharpe ratio, an algorithm trader with 2023’s performance of only 9% may still find that their strategy remains successful as this metric remains sufficiently positive.
This apparent contradiction suggests that the Sharpe ratio becomes less relevant when relative return means more than absolute return. As a result, the Information Ratio was introduced to emphasize the relative return rather than the absolute return.
Information Ratio
Information Ratio is a performance measure in finance to evaluate the risk-adjusted relative return of an investment portfolio.
It emphasizes the relative return achieved by comparing the excess return (with respect to a benchmark like VN-Index) to the tracking error. The tracking error represents the volatility of the deviation from the benchmark.
The formula:
In which:
RP : Portfolio Return
RB : Benchmark Return
RA : Active Return, the difference between the portfolio return and the benchmark return
σ(·) is the standard deviation function
A higher IR indicates that the investment has generated better risk-adjusted returns relative to its benchmark. It suggests that the investment strategy or manager has added value beyond what can be explained by market movements alone.
The Information Ratio is often used to evaluate algorithm performance along with its consistency known as tracking error (standard deviation). A low tracking error indicates consistent performance. A high tracking error suggests volatile returns that may not consistently in the long run.
Note that, if the risk-free rate is the benchmark, and there’s no risk associated with the benchmark return, the Information Ratio and Sharpe Ratio should yield the same result.
Sharpe Ratio or Information Ratio in Algorithmic Trading?
In Algorithmic Trading, certain strategies such as smart beta or uptrend grid (commonly known as the bull market grid), Information Ratio give investors deeper insight on algorithm performance when compared with Sharpe Ratio.
However, in other strategies such as market neutral, price momentum, mean-reversion, event-driven, market-making, scalping, ETF Front-Runner, Arbitrage, Grid and Sniffing, Sharpe Ratio remains a useful metric.
In short, any long bias strategies should use Information Ratio instead of Sharpe Ratio.
The following table summarizes the key differences.
Additional Usage of Information Ratio
An algorithmic trader can use the recommended IR range below to quickly evaluate the robustness of an algorithm performance.
Lastly, Information Ratio can serve not only as a primary criterion to evaluate long bias strategies but also as an objective function in the optimization phase.
In conclusion, understanding Information Ratio and its applications provides algorithmic traders a practical metric to evaluate algorithm performance, potentially helping to improve investment decisions.