Turnover-Adjusted Information Ratio

TL;DR

This paper analyzes how turnover costs affect the information ratio in investment management, revealing that optimizing turnover can improve performance, contrary to traditional beliefs.

Contribution

It extends the fundamental law of active management by explicitly incorporating turnover costs and volatility, providing a more accurate IR assessment.

Findings

Turnover-adjusted IR is lower than traditional IR when ignoring costs.

Limiting or optimizing turnover can enhance IR and investment performance.

Mathematical derivations and simulations support the impact of turnover on IR.

Abstract

In this paper, we study the behavior of information ratio (IR) as determined by the fundamental law of active investment management. We extend the classic relationship between IR and its two determinants (i.e., information coefficient and investment "breadth") by explicitly and simultaneously taking into account the volatility of IC and the cost from portfolio turnover. Through mathematical derivations and simulations, we show that - for both mean-variance and quintile portfolios - a turnover-adjusted IR is always lower than an IR that ignores the cost from turnover; more importantly, we find that, contrary to the implication from the fundamental low but consistent with available empirical evidence, investment managers may improve their investment performance or IR by limiting/optimizing trade or portfolio turnover.