What is the information coefficient (CI)?

B2B ForumCategory: Finance and LawWhat is the information coefficient (CI)?
nobile prize asked 1 year ago

The information coefficient (CI) is a measure used to assess the skill of an investment analyst or an active portfolio manager. The information coefficient shows how closely the analyst’s financial projections match actual financial results. The CI can range from 1.0 to -1.0, where -1 indicates that the analyst’s forecasts are unrelated to the actual results and 1 indicates that the analyst’s forecasts perfectly matched the actual results.

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KEY TIPS

The information coefficient (CI) is a measure used to assess the skill of an active investment analyst or portfolio manager.

A CI of +1.0 indicates a perfect prediction of actual returns, while a CI of 0.0 indicates that there is no linear relationship. A CI of -1.0 indicates that the analyst always fails to make a correct prediction.

The IC should not be confused with the information ratio (IR). IR is a measure of an investment manager’s skill, comparing a manager’s excess returns to the amount of risk taken.

The formula for the IQ is

\ begin {aligned} & \ text {IC} = (2 \ times \ text {Correct proportion}) – 1 \\ & \ textbf {where:} \\ & \ text {Correct proportion} = \ text {Prediction proportion done} \\ & \ text {correctly by analyst} \\ \ end {aligned}

CI = (2 × Correct proportion) −1

where:

Correct proportion = Proportion of predictions made

correctly by the analyst

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Explaining the information coefficient

The information coefficient describes the correlation between predicted and actual stock returns, which is sometimes used to measure the contribution of a financial analyst. A CI of +1.0 indicates a perfect linear relationship between predicted and actual returns, while a CI of 0.0 indicates that there is no linear relationship. A CI of -1.0 indicates that the analyst always fails to make a correct prediction.

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An information coefficient (CI) score close to +1.0 indicates that the analyst has a great ability to forecast. But in reality, if the definition of “correct” is that the analyst’s prediction coincided with the direction (up or down) of the actual results, then the odds of getting the correct forecast are 50/50. Therefore, even an unskilled analyst could be expected to have a CI of around 0, which means that half of the forecasts were correct and half were incorrect. A score close to 0 reveals that the analyst’s forecasting skills are no better than results that might be achieved by chance, suggesting that IQs close to -1 are rare.

The IC should not be confused with the information ratio (IR). IR is a measure of an investment manager’s skill, comparing a manager’s excess returns to the amount of risk taken.

The CI and IR are components of the Fundamental Law of Active Management, which states that a manager’s performance (IR) depends on the skill level (CI) and its breadth, or how often it is used.

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Information coefficient example

As a hypothetical example, if an investment analyst made two predictions and got two correct, the information coefficient would be:

\ begin {aligned} & \ text {IC} = (2 \ times 1.0) – 1 = +1.0 \\ \ end {aligned}

IC = (2 × 1.0) −1 = + 1.0

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If an analyst’s predictions were correct only half the time, then:

\ begin {aligned} & \ text {IC} = (2 \ times 0.5) – 1 = 0.0 \\ \ end {aligned}

CI = (2 × 0.5) −1 = 0.0

If anything. none of the predictions were correct, so:

\ begin {aligned} & \ text {IC} = (2 \ times 0.0) – 1 = -1.0 \\ \ end {aligned}

IC = (2 × 0.0) −1 = −1.0

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Information coefficient limitations

IQ is only meaningful to an analyst who makes a large number of predictions. This is because if there are only a small number of predictions, random chance can explain much of the results. So if there are only two predictions made and both are correct, the information coefficient is +1.0. However, if the CI is at or near +1.0 after several dozen predictions have been made, then it is much more attributable to skill than chance.

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