Calculate the information ratio as active return divided by tracking error to measure risk-adjusted portfolio outperformance.
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Portfolio Analysis
The information ratio measures how much active return a portfolio manager generates per unit of tracking error (deviation from the benchmark). It is the standard metric for evaluating active management skill.
While the Sharpe ratio measures total risk-adjusted return vs the risk-free rate, the information ratio measures active risk-adjusted return vs a benchmark. It answers: how much additional return does the manager earn per unit of active risk taken?
Higher information ratios indicate more efficient use of the active risk budget. An IR above 0.5 is generally considered good for an active equity manager.
Active return divided by its volatility.
IR = (Rp − Rb) / Tracking Error
Rp = portfolio return, Rb = benchmark return, Tracking Error = standard deviation of (Rp − Rb).
Assumes tracking error is stable. A manager with variable active positions may have unstable IR. The ratio is meaningless for passive or index-tracking strategies where tracking error should be near zero.
Frequently asked questions
Above 0.5 is considered good, above 0.75 is very good, and above 1.0 is exceptional. Most active managers have IRs between 0 and 0.5. Sustained IRs above 1.0 are extremely rare.
Tracking error is the standard deviation of the difference between portfolio and benchmark returns over a period. It measures how much the portfolio’s performance deviates from the benchmark.
Sharpe uses excess return over the risk-free rate and total standard deviation. IR uses excess return over a benchmark and tracking error. Sharpe evaluates absolute risk-adjusted performance; IR evaluates relative (active) performance.
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