The information ratio measures and compares the
active return In finance, active return refers the financial return, returns produced by an investment portfolio due to active management decisions made by the portfolio manager that cannot be explained by the portfolio's exposure to returns or to risks in the po ...
of an investment (e.g., a security or portfolio) compared to a benchmark index relative to the volatility of the active return (also known as
active risk In finance, tracking error or active risk is a measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager; it indicates how closely a portfolio follows the index to which it is benchmarked ...
or benchmark tracking risk). It is defined as the
active return In finance, active return refers the financial return, returns produced by an investment portfolio due to active management decisions made by the portfolio manager that cannot be explained by the portfolio's exposure to returns or to risks in the po ...
(the difference between the returns of the investment and the returns of the benchmark) divided by the
tracking error In finance, tracking error or active risk is a measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager; it indicates how closely a portfolio follows the index to which it is benchmarked ...
(the
standard deviation
In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, while ...
of the active return, i.e., the additional risk). It represents the additional amount of return that an investor receives per unit of increase in risk.
The information ratio is simply the ratio of the active return of the portfolio divided by the tracking error of its return, with both components measured relative to the performance of the agreed-on benchmark.
It is often used to gauge the skill of managers of
mutual fund
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV i ...
s,
hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as sho ...
s, etc. It measures the active return of the manager's portfolio divided by the amount of risk that the manager takes relative to the benchmark. The higher the information ratio, the higher the active return of the portfolio, given the amount of risk taken, and the better the manager.
The information ratio is similar to the
Sharpe ratio
In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure, and the reward-to-variability ratio) measures the performance of an investment such as a security or portfolio compared to a risk-free asset, after adjusting for its ...
, the main difference being that the Sharpe ratio uses a
risk-free return
The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time that is assumed to meet all payment obligations.
Since the risk-free ra ...
as benchmark (such as a
U.S. Treasury security) whereas the information ratio uses a risky index as benchmark (such as the
S&P500). The Sharpe ratio is useful for an attribution of the absolute returns of a portfolio, and the information ratio is useful for an attribution of the relative returns of a portfolio.
Definition
The information ratio
is defined as:
:
,
where
is the portfolio return,
is the benchmark return,