Active outperformance ratio

What Is the Information Ratio?

The Information Ratio (IR), sometimes referred to as the Active Outperformance Ratio, is a key metric in Investment Performance Measurement. It quantifies the ability of a portfolio manager to generate excess returns relative to a specific benchmark, while also accounting for the consistency of those returns³⁶. This risk-adjusted return measure is particularly valuable for evaluating actively managed portfolios, indicating how much additional return an investor receives per unit of additional risk taken beyond the benchmark³⁵. It helps to determine if an investment strategy has consistently beaten its reference index and by how much, considering the volatility of those outperforming returns.

History and Origin

The concept underlying the Information Ratio emerged from the broader field of modern portfolio theory and the increasing need to evaluate the skill of portfolio managers. While measures like the Sharpe Ratio focused on absolute risk-adjusted returns against a risk-free rate, there was a growing recognition that managers of active portfolios should be judged relative to a relevant market benchmark. The Information Ratio, also known as the "alpha-omega ratio" in some literature, measures the quality of a manager's "special information" or skill, discounted by the residual risk involved in their active bets³⁴. It became a standard tool for assessing how effectively managers generate alpha (excess return) against a chosen index, considering the variability of that alpha.

Key Takeaways

• The Information Ratio measures a portfolio's or manager's excess return over a benchmark, relative to the volatility of those excess returns (tracking error)³³.
• A higher Information Ratio generally indicates a more consistent and skillful generation of alpha compared to the benchmark³¹, ³².
• It is widely used to evaluate and compare the performance of active management strategies, such as those employed by mutual funds and hedge funds³⁰.
• The choice of an appropriate benchmark is critical for the Information Ratio to be meaningful and reflective of the manager's investment style²⁸, ²⁹.

Formula and Calculation

The Information Ratio (IR) is calculated by dividing the active return (the difference between the portfolio's return and the benchmark's return) by the tracking error. The tracking error is the standard deviation of the active returns.

The formula for the Information Ratio is:

$IR = \frac{R_p - R_b}{\sigma_{p-b}}$

Where:

• (R_p) = Portfolio's return
• (R_b) = Benchmark's return
• (\sigma_{p-b}) = Standard deviation of the difference between the portfolio's return and the benchmark's return (i.e., tracking error)

The numerator, (R_p - R_b), represents the active return or excess return generated by the portfolio relative to its benchmark. The denominator, (\sigma_{p-b}), measures the volatility of these active returns, effectively quantifying the risk taken to achieve that outperformance²⁶, ²⁷.

Interpreting the Information Ratio

Interpreting the Information Ratio involves assessing both the magnitude and consistency of a manager's outperformance. A positive IR indicates that the portfolio has generated returns above its benchmark, while a negative IR signifies underperformance²⁵. Generally, a higher Information Ratio is preferred, as it suggests that the portfolio manager has achieved greater excess returns for each unit of active risk taken.

Investment professionals often consider an IR above 0.5 to be good, while an IR of 0.70 or above is considered very good, and 1.0 or higher is exceptional²⁴. However, what constitutes a "good" Information Ratio can depend on the asset class, market conditions, and the specific investment strategy employed. It is also essential to consider the time horizon over which the IR is calculated; longer track records tend to provide a more reliable assessment of a manager's abilities²³.

Hypothetical Example

Consider two hypothetical investment portfolios, Portfolio A and Portfolio B, both benchmarked against the S&P 500 Index over a year.

• Portfolio A:

  • Annual Return: 12%
  • Benchmark (S&P 500) Return: 10%
  • Standard Deviation of Active Returns (Tracking Error): 2%

• Portfolio B:

  • Annual Return: 13%
  • Benchmark (S&P 500) Return: 10%
  • Standard Deviation of Active Returns (Tracking Error): 5%

Let's calculate the Information Ratio for each:

Portfolio A (IR):
Active Return = 12% - 10% = 2%
IR = ( \frac{2%}{2%} ) = 1.00

Portfolio B (IR):
Active Return = 13% - 10% = 3%
IR = ( \frac{3%}{5%} ) = 0.60

In this example, Portfolio A generated a lower active return (2% vs. 3% for Portfolio B), but it did so with much less active risk, resulting in a higher Information Ratio of 1.00 compared to Portfolio B's 0.60. This suggests that Portfolio A's manager was more efficient at generating excess returns relative to the risk taken, making it a more desirable outcome from a risk-adjusted perspective. This highlights the importance of considering both return and risk, and for this, risk-adjusted performance measures are key.

Practical Applications

The Information Ratio is a fundamental tool across several areas of finance:

• Manager Selection and Evaluation: Investors, consultants, and institutional allocators widely use the Information Ratio to assess and compare the skill of fund managers²¹, ²². It helps identify managers who consistently generate alpha relative to their stated objectives and peers, thereby providing value beyond passive indexing²⁰. For instance, a study on hedge funds by the Federal Reserve found that while more active funds could generate higher raw returns, the most active managers often used their skills to manage portfolio risk, leading to higher risk-adjusted returns¹⁹.
• Portfolio Construction: The IR assists in optimizing portfolio allocations by helping determine how much weight to assign to an actively managed component within a broader portfolio, aligning with a defined risk budget¹⁸.
• Performance Attribution: When combined with other metrics, the Information Ratio contributes to performance attribution analysis, helping to decipher whether a portfolio's outperformance (or underperformance) is due to manager skill, market timing, or simply taking on more risk¹⁷.
• Performance-Based Fees: Some hedge funds and other investment vehicles incorporate the Information Ratio into their fee structures, tying performance fees to the manager's ability to generate strong, risk-adjusted excess returns¹⁶.

Limitations and Criticisms

Despite its widespread use, the Information Ratio has several limitations and criticisms:

• Backward-Looking Metric: The IR is calculated using historical data, and past performance does not guarantee future results¹⁵. A high IR in the past does not ensure continued outperformance, as market conditions and manager capabilities can change.
• Benchmark Selection: The choice of benchmark significantly influences the Information Ratio¹³, ¹⁴. If an inappropriate or easily beaten benchmark is selected, the IR might appear artificially high, making the manager seem more skilled than they are¹².
• Time Horizon Sensitivity: The Information Ratio can be sensitive to the measurement period. Short-term IRs may not be indicative of long-term capabilities, and a manager's performance might appear inconsistent over shorter periods even if their long-term investment philosophy is sound¹⁰, ¹¹.
• Does Not Account for Skewness or Kurtosis: The IR relies on standard deviation, which assumes returns are normally distributed. It may not fully capture the impact of non-normal return distributions, such as those with significant skewness (asymmetry) or kurtosis (fat tails), which represent extreme risks or opportunities not fully captured by tracking error⁹. Academic research has also explored why simply maximizing the Information Ratio might be an incorrect objective, particularly when considering the optimal allocation for an entire portfolio and its overall risk-adjusted returns⁸.
• Limited Scope: The Information Ratio focuses solely on excess returns relative to a benchmark and the consistency of those returns. It does not provide insight into the manager's investment process, risk management techniques, or the quality of their decision-making⁷.

Information Ratio vs. Sharpe Ratio

The Information Ratio and the Sharpe Ratio are both crucial risk-adjusted performance measures in finance, but they serve different purposes and use different benchmarks. The fundamental distinction lies in their denominators and the type of risk they assess.

While the Sharpe Ratio assesses the reward for taking on total risk, the Information Ratio specifically evaluates the reward for taking on active risk relative to a chosen benchmark⁶. An investor aiming to diversify a portfolio that is heavily indexed might use the Information Ratio to select an active investment that offers superior benchmark-relative performance.

FAQs

What is considered a good Information Ratio?

While there's no universally "perfect" number, an Information Ratio of 0.4 or higher is often considered good, 0.70 or higher is very good, and 1.0 or higher is exceptional⁵. However, this can vary by asset class and the specific market environment.

Why is the Information Ratio important for active managers?

The Information Ratio is crucial for active managers because it assesses their ability to consistently beat a benchmark while managing the associated risks³, ⁴. It provides a standardized way to compare their skill against peers and demonstrate the value they add beyond simply tracking an index.

Can the Information Ratio be negative?

Yes, the Information Ratio can be negative if the portfolio's returns are consistently lower than the benchmark's returns, indicating underperformance¹, ². A negative IR suggests that the manager is not effectively generating positive excess returns relative to the risk taken.

How is tracking error related to the Information Ratio?

Tracking error is the denominator of the Information Ratio and measures the standard deviation of the differences between the portfolio's returns and the benchmark's returns. It represents the active risk taken by the manager. A lower tracking error for a given active return implies a higher (and thus better) Information Ratio, signifying more consistent outperformance.