What is the Information Ratio?

The Information Ratio (IR) is a financial metric used to assess the performance of an investment portfolio compared to a benchmark. It measures the amount of excess return a portfolio generates relative to the risk it takes to achieve that return.

Rather than just evaluating return or volatility separately, the Information Ratio balances both by dividing the excess return by the tracking error. This makes it a valuable tool for evaluating fund managers or strategies that aim to outperform an index.

How to Calculate the Information Ratio

The formula for calculating the Information Ratio is:
Information Ratio = (Portfolio Return − Benchmark Return) / Tracking Error

The tracking error is the standard deviation of the difference between the portfolio's returns and those of the benchmark. It shows how consistently the portfolio diverges from the benchmark.

For example, if a portfolio earns a return of 12%, the benchmark earns 8%, and the tracking error is 2%, the Information Ratio is (12 − 8) / 2 = 2. This means the portfolio is generating 2 units of excess return for every unit of benchmark-relative risk.

Why Use the Information Ratio?

The Information Ratio is essential for investors who want to determine whether outperformance is due to skill or chance. A consistently high IR often suggests that the manager has real skill in delivering excess returns with a controlled level of risk.

It's also helpful in comparing different active strategies. By showing how efficiently a manager delivers return over risk, investors can make more informed decisions when allocating assets among funds or portfolios.

Interpreting the Information Ratio

An IR above 0.5 is generally considered good, while an IR above 1 is excellent. It suggests a strong ability to generate returns above the benchmark consistently and efficiently.

A negative Information Ratio indicates underperformance relative to the benchmark. However, it's important to consider the investment timeframe and strategy objectives when interpreting the number.

Practical Applications

Financial advisors and fund analysts often use the Information Ratio when evaluating mutual funds, hedge funds, or portfolio managers. It helps them identify which funds may deliver long-term value over a passive benchmark.

It's also widely used in portfolio construction and optimization. Investors seeking alpha-generating strategies use the IR as a screening tool to identify managers who are consistently outperforming without excessive risk.

Conclusion

The Information Ratio is a powerful measure for evaluating the effectiveness of investment strategies. It balances return and risk by showing how much excess return is achieved for each unit of volatility relative to a benchmark.

When used alongside other performance metrics, the IR can provide deeper insight into the quality of portfolio management. For investors aiming to outperform the market, it’s a key figure worth monitoring closely.