Information Ratio
Beating the benchmark isn't all the same skill. Beating it big once by luck is different from beating it a little, steadily, every year. The information ratio captures that 'steadiness.'
What is the information ratio
The Information Ratio (IR) is the excess return divided by the volatility of that excess return. The formula is excess return ÷ tracking error.
The numerator is 'how much it beat the benchmark on average,' and the denominator is 'how erratic that excess performance was.' In other words, it measures 'how much excess return there is per unit of active risk (the degree of departure from the benchmark).'
Tracking error as the denominator
Tracking error is the standard deviation of excess return. If you beat the benchmark by a similar amount each year, tracking error is small; if you beat it big some years and lose big others, tracking error is large.
Even at the same average excess return, the smaller the tracking error, the higher the information ratio. In other words, the information ratio checks 'whether the skill is steady rather than luck.' A management that had one big hit by chance may have a large excess return but a low information ratio.
The Sharpe ratio looks at risk-adjusted return 'versus the risk-free rate,' while the information ratio looks at risk-adjusted excess return 'versus the benchmark.' The standards differ.
How to read the information ratio
The higher the information ratio, the more stably the active management beat the benchmark. That said, an information ratio above 1 is actually rare. Many places tout a high information ratio to raise funds, but cases where it's sustained over a long period are uncommon.
Also, the information ratio is based on past data, so it doesn't guarantee the future, and it may be a figure before subtracting costs and taxes. Rather than trusting one number alone, you should view the period, costs, and appropriateness of the benchmark together.
Frequently Asked Questions
Q. How does the information ratio differ from the Sharpe ratio?
Both measure 'return versus risk,' but the standards differ. The Sharpe ratio divides excess return versus the risk-free rate by total volatility. The information ratio divides excess return versus the benchmark by tracking error (the volatility of excess return). The information ratio is often used to evaluate active management.
Q. What does it mean if the information ratio is negative?
It means that on average it lagged the benchmark. If the excess return itself is negative (−), the information ratio is negative too. In this case, you can view the active management as having actually done harm.
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📋 Results are based on historical data; past returns do not guarantee future returns.
📋 This service is provided for educational purposes to help you understand investing, not as investment advice.