Information Ratio: Active Return Over Tracking Error

Key Takeaways

• The information ratio divides active return by tracking error, the volatility of that active return.
• Active return is the portfolio return minus the benchmark return over the same period.
• It captures consistency, since a manager who beats the index steadily scores higher than one who beats it erratically.
• Investors often confuse a high raw return with skill, but only the information ratio adjusts for benchmark-relative risk.

What It Is

The information ratio compares a portfolio against a benchmark rather than against the risk-free rate. The numerator is active return, the difference between the portfolio's return and its benchmark's return. The denominator is tracking error, also called active risk, which is the standard deviation of that active return.

It is conceptually a Sharpe ratio for active management. Instead of asking how much return you earned per unit of total risk, it asks how much you beat the index per unit of the risk you took by straying from it.

The information ratio is widely used to evaluate active fund managers, because it isolates the value they add beyond simply tracking the market.

The Intuition

Beating a benchmark by 3 percent in one wild year is not the same as beating it by 1 percent every year. The first could be luck. The second looks like skill.

Tracking error captures how much a manager's results bounce around the benchmark. A manager who consistently adds a small edge has low tracking error, so even a modest active return produces a high information ratio. A manager who swings far above and below the index has high tracking error, which drags the ratio down even if the average outperformance is large. The measure rewards reliability, not just size.

How the Information Ratio Works

The formula is:

Information Ratio = (Rp - Rb) / Tracking Error

Where Rp is the portfolio return, Rb is the benchmark return, and tracking error is the standard deviation of the active returns (Rp minus Rb) over the period.

In practice you compute the active return for each period, take the average to get the numerator, and take the standard deviation of those same active returns to get the denominator. A higher information ratio is better. As a rough guide, practitioners often view 0.5 as good, 0.75 as very good, and 1.0 as exceptional, though these bands vary by strategy.

Worked Example

A fund returns 11 percent over a year while its benchmark returns 8 percent. The active return is 3 percent. Over the same period, the standard deviation of the fund's monthly active returns annualizes to 4 percent.

Information Ratio = (11% - 8%) / 4% = 3% / 4% = 0.75

Now compare a second fund that also beat the benchmark by 3 percent, but with much choppier results, giving a tracking error of 8 percent:

Information Ratio = 3% / 8% = 0.375

Both funds added the same 3 percent of outperformance, yet the first did it far more consistently and scores twice as high. That consistency is exactly what allocators want to see.

Common Mistakes

1. Picking the wrong benchmark. Active return and tracking error both depend on the index chosen. A small-cap fund measured against a large-cap index produces a meaningless ratio. Match the benchmark to the mandate.
2. Ignoring the sign of active return. A negative active return with low tracking error gives a negative ratio. A consistently small underperformance can look "stable" but is still losing to the index.
3. Annualizing inconsistently. If active return is annual but tracking error is monthly, the ratio is wrong by a large factor. Keep both on the same frequency.
4. Treating it as identical to the Sharpe ratio. Sharpe uses the risk-free rate and total volatility. The information ratio uses the benchmark and benchmark-relative volatility. They answer different questions.
5. Reading it without a sample size. A high ratio over six months can be noise. Skill claims need several years of active returns to be credible.

Frequently Asked Questions

What is the information ratio in simple terms? The information ratio shows how much a fund beats its benchmark for each unit of extra risk it took by deviating from that benchmark. A higher number means more consistent, reliable outperformance.

How does the information ratio affect investment decisions? It helps allocators judge whether a manager's outperformance is skill or luck. A fund that beats its index steadily, as the worked example shows, scores higher than one that beats it by the same amount erratically, which favors steadier managers.

What is a real-world example of the information ratio? A fund that returns 11 percent against an 8 percent benchmark, with 4 percent tracking error, scores 0.75. A choppier fund with the same 3 percent edge but 8 percent tracking error scores only 0.375.

How can investors use the information ratio effectively? Use the correct benchmark, keep return and tracking error on the same frequency, and require several years of data. Then compare it across managers with similar mandates rather than across unrelated strategies.

How is the information ratio different from Jensen's alpha? Jensen's alpha measures excess return after adjusting for market risk (beta) using CAPM. The information ratio measures outperformance versus a benchmark per unit of tracking error, focusing on consistency rather than a CAPM-implied baseline.

Sources

1. Corporate Finance Institute. "Information Ratio." https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/information-ratio/
2. Wall Street Prep. "Information Ratio." https://www.wallstreetprep.com/knowledge/information-ratio/
3. AnalystPrep. "Active Risk, Tracking Risk and the Information Ratio." https://analystprep.com/study-notes/cfa-level-2/explain-sources-of-active-risk-and-interpret-tracking-risk-and-the-information-ratio/
4. Trading Metrics. "Information Ratio." https://docs.tradingmetrics.com/en/technical-analysis/trading-metrics/efficiency-metrics/information-ratio

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.