Information ratio: measuring active return per unit of active risk

The information ratio measures how much active return a portfolio generates per unit of active risk taken against a benchmark. Where the Sharpe ratio evaluates total return against total risk, the information ratio focuses specifically on the excess return above a benchmark—the return that cannot be attributed to simply holding the benchmark—and divides it by the volatility of that excess return. It is the primary metric for evaluating active management skill.

What the information ratio measures

Active return is the difference between the portfolio's return and the benchmark's return in each period. A portfolio that returned 12% while its benchmark returned 10% generated 2 percentage points of active return in that period. Tracking error is the standard deviation of these active return differences across time—it measures how consistently the portfolio deviates from the benchmark, whether positively or negatively. The information ratio (IR) is the ratio of annualised active return to annualised tracking error: IR = Active Return / Tracking Error.

An information ratio of 0.5 means the portfolio generates 0.5 percentage points of active return for every 1 percentage point of tracking error. An IR of 1.0 means it generates 1 percentage point of active return per percentage point of active risk—a level considered exceptional in institutional fund management. Negative information ratios indicate that the active management is destroying value relative to the benchmark, generating negative active return for the active risk taken.

How it differs from the Sharpe ratio

The Sharpe ratio compares total return above the risk-free rate to total portfolio volatility. It evaluates whether the portfolio's absolute return justifies its absolute risk. The information ratio compares active return above a benchmark to tracking error—the volatility of that active return. It evaluates whether the active management decisions justify the deviation from the benchmark. A portfolio that holds the benchmark exactly has an information ratio of zero by definition—its active return is zero and its tracking error is zero. This makes the information ratio relevant only for actively managed portfolios, where the manager is explicitly trying to outperform a benchmark.

Grinold (1989) formalised the relationship between the information ratio and active management in the Fundamental Law of Active Management: IR ≈ IC × √BR, where IC is the information coefficient (the correlation between the manager's return forecasts and actual returns) and BR is breadth (the number of independent investment decisions per year). The law implies that skill and diversification across many independent bets, not just a few concentrated bets, are the two drivers of a high information ratio.

What the evidence shows

Empirical studies of institutional active management have found that median information ratios for active equity funds are close to zero or slightly negative after fees—consistent with the efficient market hypothesis and the arithmetic of active management (Sharpe, 1991). The distribution is wide: some managers generate consistently positive information ratios, but identifying these managers in advance from their historical IR is difficult because even genuine skill produces information ratios that vary substantially from year to year due to sampling variability.

For systematic quantitative strategies, information ratios tend to be more stable than for discretionary managers because the decision-making process is rule-based and the number of independent bets per year (breadth) is typically high. Strategies that make monthly allocation decisions across ten or more asset classes have higher breadth than strategies that hold five to ten concentrated positions, and the Fundamental Law predicts that higher breadth generates more stable information ratios for a given level of skill.

Limitations and trade-offs

The information ratio is sensitive to the choice of benchmark. A portfolio with a high information ratio against a domestic equity benchmark may have a lower ratio against a global multi-asset benchmark that better reflects the portfolio's investment universe. Benchmark choice is not neutral: a manager who selects a benchmark they can reliably beat will report a higher information ratio than one who chooses a more appropriate but more difficult benchmark. When comparing information ratios across managers or strategies, the benchmark must be verified as appropriate.

The information ratio also does not distinguish between different sources of active return: a manager who earns active return by taking systematic factor exposures (value tilt, quality tilt) has a different active management claim than one who generates genuinely idiosyncratic returns from stock selection. Both can report the same IR. Factor-adjusted active return—stripping out return attributable to factor exposures and measuring only residual return—is a more demanding but more informative evaluation of genuine active skill.

Information ratio in pfolio

The information ratio is not currently reported in pfolio Insights. For guidance on benchmark selection and how to evaluate portfolio performance relative to a relevant index, see how to choose an investment benchmark.

Related articles

• Tracking error as a portfolio metric: how far a portfolio strays from its benchmark
• Sharpe ratio explained: measuring risk-adjusted portfolio returns
• How to choose an investment benchmark: a guide to meaningful portfolio comparison
• Alpha in investing: what it means to outperform on a risk-adjusted basis