Information ratio has normally been used by plan sponsors for portfolio measurement. Can they use it effectively to monitor their pension plan’s performance?
By Andrew Tan
Most in the investment community are familiar with the term ‘information ratio’—a measure that evaluates a portfolio’s performance against risk and return and a tool used by many pension plan sponsors to gauge manager performance.
Pension plans are constantly looking at new asset classes and strategies to enhance return while minimizing risk. Information ratio allows plans to reflect on the effectiveness of their investments. Can information ratio, however, be used to evaluate the performance of the entire plan? And if so, what kind of insights could this analysis provide?
Interestingly, many plan sponsors measure the results of their investments similar to investment managers. The performance objectives in a plan’s Statement of Investment Policy and Procedure often call for the portfolio to outperform a passive benchmark. The idea is to meet certain investment goals without incurring excessive risk.
Information ratio helps sponsors measure performance of their defined benefit plan’s investments in a simple format, ideal for dissemination to a pension board or committee. The ratio becomes even more insightful when compared across the results of other pension plans. As a result, mitigating risk can become as important as performance.
For example, a plan invested in conservative assets might perform poorly during a bull market if compared to a plan with aggressive, high-return investments. This comparison, however, doesn’t take into account the lower risk the plan may have incurred through its conservative approach. Using the information ratio method, this comparison could show that by assuming less risk, the conservative plan was outperforming its peers on a risk-adjusted basis.
On the other hand, a plan might be performing well against a high returns-based group. However, that plan may have incurred significant risk to achieve those results. In this context, the plan that took on additional risk would have ranked lower using information ratio.
For information ratio to be an effective measure of risk and return, sponsors should consider it in conjunction with plans in similar peer groups. This will help plans better understand what’s driving their results—returns or risk?
How does this apply in the context of Canadian pension plans? Generally speaking, an information ratio number of 0.5(two units of active risk for every unit of excess return)is a good result. Over the past four years, large Canadian pension plans with assets greater than $1 billion have achieved an impressive median information ratio of 0.6.
Breaking out the information ratio number, active management has created excess return or value-added of 0.9% over the same period—the result of plans realizing better performance in both Canadian and non-Canadian equities against their respective benchmarks.
The median variability of excess returns or tracking error for large Canadian plans over the past four years is 1.4%. Diversification into multi-style mandates, use of passive strategies and currency hedging are contributors to lower risk for large plans. Putting it together, the median information ratio of 0.6% was achieved through both better excess returns and lower excess risk.
Sometimes, a new perspective can shed insights into plan performance. In this regard, information ratio can be used by pension plans to better assess their overall results on a riskadjusted basis—and not just portfolio returns needed—as was the case until now. As long as the benchmarks being used are appropriate, reflecting the investment options available to the plan, information ratio can be a powerful tool for measuring plan performance.
Andrew Tan is with BENCHMARK, the investment analytics arm of RBC Global Services in Toronto. andrew.tan@rbc.com.
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Breaking out the information ratio number, active management has created excess return or value-added of 0.9% over the same period—the result of plans realizing better performance in both Canadian and non-Canadian equities against their respective benchmarks.