Information Ratio

The Information Ratio (IR) is one of the most widely used metrics in professional asset management for evaluating active fund managers. Unlike the Sharpe or Treynor ratios, which compare a portfolio to a risk-free rate, the IR compares a portfolio directly to its stated benchmark — the index the manager is trying to beat.

Active return (sometimes called alpha) is simply the portfolio return minus the benchmark return over the same period. Tracking error is the standard deviation of those active returns over time. A manager who consistently beats the benchmark by small amounts will produce a high IR; a manager who occasionally crushes the benchmark but frequently lags it will have a lower IR because the high tracking error penalizes inconsistency.

Generally, an IR above 0.5 is considered good for a single-asset-class manager, and above 1.0 is considered exceptional. The ratio is particularly valuable because it embeds both skill (the ability to generate positive active returns on average) and consistency (the predictability of those returns). Both dimensions matter: a manager who averages 3% of active return with 6% tracking error is effectively gambling relative to one who averages 1% with 0.8% tracking error.

The IR has theoretical backing from the Fundamental Law of Active Management, developed by Richard Grinold, which decomposes the IR into the breadth of independent bets the manager makes and their individual skill (IC, or information coefficient). More independent, well-informed bets compound into higher sustained active returns.

One limitation is that the IR is sensitive to the choice of benchmark. If the benchmark does not match the manager's actual investment universe, both the active return and the tracking error will be distorted. Comparing IRS across managers who use different benchmarks without adjustment can be misleading.