Plethora of Mutual fund schemes based on various  market capitalization as well as style  are available for investment to informed as well as normal investors, but I suppose , when it comes to selecting the right scheme post your asset allocation, the job is not easy. Most investors  select the scheme based on  past returns for various periods , some time it is further refined by considering rolling  returns for various past periods. Though,sounds good but a caveat,  we all know that past performance is no guarantee of future performance.  Just considering the past period rolling return does not gives an idea about inherent risk attached to  Equity investments. To alleviate this  issue , your financial adviser may ask you to consider Sharpe ratio.

Sharpe ratio is calculated by subtracting the risk free rate  applicable to the investor from actual return and then dividing the reminder by standard deviation of actual returns. To simply put, Sharpe Ratio gives us an idea about how much excess return per unit of risk over the risk free rate is generated by the scheme.  Here,past periods could be 1 year trailing, 3 year trailing or 5 to 10 year trailing as per the intended future investment horizon. Sharpe Ratio which assumes normal distribution gives us a fair idea about the Total Risk i.e. both Systematic as well as Unsystematic or Idiosyncratic risk,  but still it is  based on past performance!  Also, it does not give any idea about managers stock picking or security selection ability which is very vital, if you want to make investment in small and mid cap schemes for higher returns.  Mid and Small Cap schemes are characterized by high degree of kurtosis i.e. it has fat tails in terms of large positive or negative returns , to simply put such schemes are more volatile compared to large cap schemes due to information asymmetry relating to securities contained in its portfolio.So now you have one more challenge , how to judge  manager’s stock picking or security selection ability ? Now there is a help here, manager’s stock picking or security selection ability can be quantified by calculating one more ratio viz. Information Ratio.

Information ratio divides excess returns of the scheme over the benchmark by standard deviation of such excess returns.Though Information Ratio sounds similar to Sharpe Ratio , but it is different. It is similar to the extent that it considers standard deviation, but it takes into account standard deviation of excess returns and not just actual scheme return . It is also different in respect of calculation of excess returns , it takes into account  returns of the benchmark instead of risk free rate  to calculate excess returns i.e. it subtracts benchmark returns from the actual scheme returns. Actual returns are functions of under/over weighting of securities compared to the benchmark in active management, though various factor exposure of the scheme portfolio and benchmark will be similar. Also , some securities forming part of the scheme portfolio could be outside the benchmark selected to calculate the actual returns, particularly securities with tiny market capitalization. Hence, manager’s security selection ability can be quantified through Information Ratio roughly and the Information Ratio can be considered some what superior to Sharpe Ratio.  However, a word of caution , the kind of benchmark is selected will determine the quality of Information Ratio i.e. if the scheme in question is mid and small cap , but benchmark selected is relevant to the large cap, then there is a problem. Again the actual and benchmark returns are past returns!! So the issue of prediction of future still remains. Can the future be reliably predicted ? Does the Information Ratio has predictive power of future ? The answer could be yes, if auto correlations are found in Information Ratio i.e. correlation among Information Ratio with itself for various legged or past periods.

(Note:  This article is written only for knowledge sharing and discussion purpose  )