Information ratio
What is Information ratio?
The information ratio measures average benchmark-relative return per unit of tracking error.
The information ratio should show annualized active return and tracking error from the same observations, with benchmark and period explicit. Confidence is low in short samples, and a high value can reflect stale pricing or one event. It should be interpreted alongside attribution, capacity, and implementation cost.
Capacity and transaction cost can prevent a historically efficient active process from scaling to more capital.
A rolling display should retain active-return and risk components and identify observations that dominate the estimate. Manager review should compare the achieved ratio with the mandate's active-risk budget rather than reward low risk created by unintended benchmark hugging.
Formula
Information ratio equals annualized active return divided by annualized tracking error, using consistent observations. Active return is portfolio minus benchmark. A positive ratio indicates reward for historical active variability; a negative ratio indicates underperformance. Arithmetic and geometric annualization choices should be stated and aligned.
Interpretation
A higher ratio can indicate more efficient active management, but it does not describe absolute risk, drawdown, leverage, or suitability. A concentrated strategy can generate attractive active return with high tracking error, while a benchmark-hugging strategy can show an unstable ratio when both numerator and denominator are extremely small.
Example
If a portfolio earns 2% annualized active return with 4% tracking error, its information ratio is 0.5. This does not mean it will earn 0.5% or has a 50% success probability. It summarizes one historical relationship and is uncertain, particularly when the sample is short.
Evaluation
Assess consistency across rolling periods, market regimes, sleeves, and attribution. A high ratio can reflect factor exposure, stale valuation, benchmark mismatch, one event, or luck. Fees and transaction costs reduce active return. Capacity can erode repeatability. Statistical confidence and economic rationale matter alongside the point estimate.
Practical reporting
State benchmark, period, frequency, annualization, gross or net basis, currency, and observations. Show active return and tracking error separately so users can reconstruct the ratio. Do not compare information ratios against different benchmarks or rank negative values mechanically. Pair with alpha, active share, attribution, drawdown, and mandate limits.
Sources and further reading
- Portfolio Performance Evaluation, CFA Institute