Information Ratio: Measuring Active Return per Unit of Tracking Risk

For educational purposes only; not investment advice.

Direct answer

The information ratio compares a portfolio’s average return above its benchmark with the volatility of that excess return. It asks: how much active return was earned for each unit of tracking risk?

Information ratio = active return / tracking error

Active return is the portfolio return minus the benchmark return. Tracking error is the standard deviation of that active-return series. The ratio is mainly used for active funds, model portfolios, and strategies judged against a specific benchmark.

How it works

Start with returns measured at the same frequency, such as monthly portfolio total returns and monthly benchmark total returns. Subtract benchmark return from portfolio return for each period. That produces the active-return series.

Then calculate:

the average active return;
the standard deviation of active returns;
annualization using a consistent frequency.

For monthly data, a common approximation is:

Annualized active return = monthly average active return × 12

Annualized tracking error = monthly tracking error × √12

The benchmark must match the strategy’s investable universe. A small-cap fund compared with a mega-cap index can show a misleading information ratio because the benchmark mismatch turns style exposure into apparent skill.

Example

Suppose a portfolio has average monthly active return of 0.20% versus its proper benchmark. The monthly tracking error is 1.00%.

Annualized active return:

0.20% × 12 = 2.40%

Annualized tracking error:

1.00% × √12 ≈ 3.46%

Information ratio:

2.40% / 3.46% ≈ 0.69

Now compare another fund that beat its benchmark by 3.00% per year but had tracking error of 12.00%:

3.00% / 12.00% = 0.25

The second fund had more raw outperformance, but less active return per unit of benchmark-relative volatility.

Risks

Benchmark risk: the wrong benchmark can make ordinary style exposure look like skill.
Sample risk: short histories can produce unstable ratios.
Outlier risk: a few months can dominate the result.
Fee risk: gross-of-fee and net-of-fee returns can tell different stories.
Survivorship risk: failed funds disappear from databases, making averages look better.
Non-normal return risk: options, illiquid assets, and concentrated positions can hide tail risk not captured by standard deviation.
Regime risk: a high historical ratio can vanish when rates, volatility, sector leadership, or liquidity change.

Common misconceptions

A higher information ratio is not a guarantee of future outperformance.

Information ratio is not the same as Sharpe ratio. Sharpe ratio compares return above a risk-free rate with total volatility; information ratio compares active return with benchmark-relative volatility.

The formula does not identify why a fund outperformed. The source could be security selection, factor exposure, sector concentration, leverage, timing, or luck.

One ratio should not replace drawdown, liquidity, tax impact, turnover, fees, and whether the benchmark is appropriate.

Sources

SEC Investor.gov and FINRA: fund performance, benchmark, cost, and investor-reporting context.
William F. Sharpe / Stanford and Journal of Finance: risk-adjusted performance measurement background.