Actively managed funds can deliver market-beating returns, but many don’t. If you’re paying fees to a fund manager, you want to be confident they’ll deliver better results than cheaper, passive alternatives. Information ratio helps investors of all kinds evaluate the performance of an investment portfolio relative to a benchmark index so they can choose the best investment. Here’s what you need to know.

## What Is the Information Ratio?

The information ratio is a performance measure that helps investors answer two questions about an actively managed investment fund.

1. How successfully did the fund outperform the market over a given period?
2. How consistent was the fund’s performance relative to the market?

The information ratio measures a fund manager’s ability to consistently generate excess returns relative to a benchmark, taking into account the level of risk assumed. It is particularly useful for comparing the performance of two or more fund managers with similar investment strategies.

A high information ratio indicates an investment that is successfully and consistently outperforming a benchmark index. Generally, it’s an indication that the fund manager is doing a good job.

## How To Calculate the Information Ratio

The information ratio formula is:

Information ratio = (portfolio return – benchmark return)/tracking error.

Let’s take a closer look at the variables that make up the information ratio formula.

### What Are Excess Returns?

The numerator of the information ratio formula is excess returns.

In this context, excess returns are portfolio returns that exceed those generated by a chosen benchmark index. Excess returns indicate how a portfolio is performing relative to the broader market.

To calculate, simply subtract returns generated by the index from returns generated by the portfolio.

### What Is Tracking Error?

The denominator of the information ratio formula is the portfolio’s tracking error.

This variable represents how closely the investment portfolio tracks the price behavior of the chosen benchmark index. It is a measure of risk and volatility.

It is calculated by finding the standard deviation of a portfolio’s returns from a benchmark index.

A low tracking error means the investment portfolio consistently outperforms the index while a high number indicates a more volatile performance.

#### What Is Standard Deviation?

Standard deviation (SD) is a powerful measure of how much a data set differs from the mean or average. A more visual way to think about standard deviation is as a measure of the scatter of data around a mean.

A large SD means the data points cover a large range while a small SD means the data points are all close together. For example, imagine you have a group of children aged 1 to 18. The standard deviation of their heights will be higher than a group of children who are all aged 2.

When calculating tracking error, the data set is portfolio returns over time. Instead of measuring the SD from a mean, tracking error measures how returns are scattered around the benchmark rate.

#### How To Calculate Tracking Error

There are two ways to calculate tracking error – a simple method and a more complex method. Here are the formulae.

1. Portfolio return – benchmark return
2. SD of (portfolio returns – benchmark returns)

Now, let’s take a look at the steps involved in the more complex method that involves standard deviation.

1. Calculate the deviation (difference) between each data point and the index e.g. portfolio return for January – S&P 500 return for January.
2. Square each deviation.
3. Calculate the sum of the results.
4. Divide by the number of data points in the data set.

#### Tracking Error Calculation Example

Say you wanted to calculate the tracking error for a fictional investment portfolio using the S&P 500 as your benchmark rate. Steps 1-3 have been completed in the table below.

 Date Portfolio Return S&P 500 Return Deviation from Index Deviation Squared Jan 2023 0.14% -5.9% 6.04% 36.48 Feb 2023 2% -2.6 % 4.6% 21.16 Mar 2023 -2.3% 3.5% 5.8% 33.64 Apr 2023 -1.6% 1.4% 3% 9 May 2023 4.4% 0.2% 4.2% 17.64 Jun 2023 2.7% 6.4% 3.7% 13.69 Jul 2023 0.8% 3.1% 2.3% 5.29 Aug 2023 1.2% -1.7% 2.9% 8.41 Sep 2023 3.1% -4.8% 7.9% 62.41 Oct 2023 0.5% -2.2% 2.7% 7.29 Nov 2023 1.1% 8.9% 7.8% 60.84 Dec 2023 -0.5% 4.4% 4.9% 24.01 Sum 299.8616

Now we divide 299.8616 by 12 because we have returns for 12 months. This equals approximately 25.

The square root of 25 is 5. Therefore, the tracking error for the portfolio is 5.

## Information Ratio Example

Let’s compare two fund managers by calculating their information ratios.

• Fund A has annualized returns of 8% and a tracking error of 9%.
• Fund B has annualized returns of 7% and a tracking error of 4%.
• The benchmark index has annualized returns of 1%.

We know that:

Information ratio = (portfolio return – benchmark return)/tracking error

Therefore:

Fund A’s information ratio = (8-1)/9 = approximately 0.77

Fund B’s information ratio = (7-1)/4 = approximately 1.5

Although the manager of Fund A generated slightly higher returns, their portfolio has a lower (i.e. worse) information ratio. This is partly because it has a higher tracking error, which means more volatility relative to the benchmark rate.

Fund B has a higher information ratio, meaning that the manager of Fund B has performed better than the manager of Fund A in terms of consistently generating returns that outperform the index.

By comparing the information ratios of these two investment portfolios, we can ascertain that, all things being equal, Fund B is a better investment. Naturally, these kinds of decisions shouldn’t be made with a single metric, so make sure to research prospective investments from all angles. The information ratio is a powerful tool but it shouldn’t be the only one in your toolbelt.

## What Is a Good Information Ratio?

A higher information ratio is preferable because it indicates that the fund is consistently outperforming the benchmark. An information ratio of:

• > 1 is excellent
• 0.7 – 1 is very good
• 0.4 – 0.6 is good
• < 0 indicates that the fund is generating lower returns than the benchmark

That being said, a ‘good’ information ratio depends on the type of investment that you are looking at, market trends in the sector, your investment objectives, and your risk appetite. For example, look at the massive variance between regions and sectors since 2007.

Experts advise that investors should assess a portfolio’s information ratio alongside measures of risk-adjusted performance, such as the Sortino ratio and Treynor ratio, as well as contextual information like the economic climate, trends in the financial markets, fees, and the fund manager’s investment style.

## How to Choose the Right Benchmark

When selecting a benchmark rate for an information ratio calculation, think about the industry and the investment strategy of the investment portfolio you are evaluating. If the portfolio is focused on:

• small-cap stocks, consider using the Russell 2000
• large-cap stocks, consider using the S&P 500
• tech companies, consider using the NASDAQ
• real estate, consider using the Dow Jones

## Limitations of the Information Ratio

The information ratio is a helpful approximation of a fund manager’s risk-adjusted performance but it has several limitations, including the following.

1. It is based on past performance – which isn’t always a predictor of future investment performance. The fund manager may have gotten lucky or the sector they invest in may have had a good year.
2. The benchmark is a subjective choice. There are thousands of benchmarks out there, from the S&P 500 to Lipper Indexes, MSCIs, and SPDRs. If an inappropriate benchmark is selected, you won’t be comparing apples to apples.
3. It does not account for non-financial factors. For example, some investors may consider the ethical or environmental implications of investing in certain sectors or companies.
4. It does not apply to investments with asymmetric return strategies like those used by hedge funds because they may have an abnormal distribution of returns.

## Information Ratio vs. Sharpe Ratio

Both the Sharpe ratio and the information ratio are used for measuring the risk-adjusted performance of an investment fund, but the ratios provide different insights.

The Sharpe ratio indicates how well investors are compensated for choosing a risky asset rather than a risk-free investment.

The information ratio, on the other hand, indicates how much reward a portfolio manager generated by taking risks and deviating from a benchmark.

 Sharpe Ratio Information Ratio Best used to rank and compare… funds fund managers Compares a fund’s returns to… the risk-free rate a benchmark index Measures volatility using… standard deviation tracking error

The Sharpe ratio compares excess returns (relative to the risk-free rate) to the standard deviation of portfolio returns.

Investors should look at both ratios when comparing investment options. A fund with a Sharpe ratio >1 and an information ratio >0.4 is worth further consideration.

## Do Your Own Research With the Information Ratio

The active vs. passive investing debate is decades old and continues to be divisive. Passively managed index funds tend to have lower expenses and often outperform actively managed funds. Only highly skilled fund managers can beat benchmark returns. The information ratio makes it easier to assess and rank a fund manager’s competency to ensure you are putting your money in the most capable hands.