Information ratio: Meaning, Criticisms & Real-World Uses

What Is Information Ratio?

The Information Ratio (IR) is a crucial metric in portfolio theory that assesses the performance of an active investment portfolio or manager relative to a chosen benchmark. Specifically, the information ratio measures the amount of excess return generated by a portfolio for each unit of active risk taken. It provides insights into the consistency and skill of active management decisions, highlighting how efficiently a manager utilizes their investment insights to outperform a benchmark while managing relative risk. A higher information ratio indicates superior risk-adjusted performance, suggesting that the manager is generating more return above the benchmark for a given level of tracking error. This makes the information ratio a vital tool in evaluating active management strategies.

History and Origin

The concept of the Information Ratio was prominently introduced and popularized by Richard Grinold and Ronald Kahn in their seminal 1995 book, Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk.⁴ Their work provided a comprehensive framework for active investing, emphasizing the importance of understanding and measuring a manager's ability to generate returns beyond a benchmark, adjusted for the unique risks taken. The information ratio quickly became a cornerstone in performance attribution and manager evaluation within the institutional investment community. Grinold and Kahn's "Fundamental Law of Active Management" further elaborated on the drivers of the information ratio, linking it to a manager's skill (information coefficient) and the number of independent investment decisions (breadth) they make.

Key Takeaways

The Information Ratio measures a portfolio's active return per unit of active risk relative to a benchmark.
It is a key metric for evaluating the skill and consistency of active investment managers.
A higher information ratio generally indicates better risk-adjusted performance.
The metric helps distinguish between returns generated by genuine skill and those resulting from taking on higher, uncompensated risk.
It is widely used in manager selection, portfolio optimization, and risk management.

Formula and Calculation

The Information Ratio (IR) is calculated by dividing the portfolio's active return (excess return) by its active risk (tracking error).

The formula for the Information Ratio is:

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

Where:

(R_p) = Portfolio's actual return
(R_b) = Benchmark's actual return
(\sigma_{p-b}) = Tracking error, which is the standard deviation of the difference between the portfolio's returns and the benchmark's returns. This measures the volatility of the active return.

The numerator, (R_p - R_b), is often referred to as the portfolio's alpha when considering the benchmark as a proxy for the market factor.

Interpreting the Information Ratio

Interpreting the Information Ratio involves understanding that it is a measure of efficiency in generating active returns. A positive information ratio indicates that the portfolio has outperformed its benchmark, on average, for the level of risk taken. Conversely, a negative information ratio suggests underperformance relative to the benchmark.

Generally, higher information ratios are preferred. While there's no universally agreed-upon threshold, investment professionals often consider an IR of 0.50 as "good," 0.75 as "very good," and 1.0 or higher as "exceptional."³ These benchmarks help in assessing an active manager's capability. However, the interpretation should also consider the investment universe, the investment strategy employed, and the time horizon over which the ratio is calculated. A consistently high information ratio over an extended period is a strong indicator of a manager's skill and effective portfolio management.

Hypothetical Example

Consider two hypothetical active portfolio managers, Manager A and Manager B, who both aim to outperform the S&P 500 benchmark. Over the past year:

S&P 500 Benchmark Return ((R_b)): 10%
Manager A's Portfolio:
- Return ((R_p)): 12%
- Active Return ((R_p - R_b)): 12% - 10% = 2%
- Tracking Error ((\sigma_{p-b})): 3%
- Information Ratio (IR): (2% / 3% = 0.67)
Manager B's Portfolio:
- Return ((R_p)): 14%
- Active Return ((R_p - R_b)): 14% - 10% = 4%
- Tracking Error ((\sigma_{p-b})): 8%
- Information Ratio (IR): (4% / 8% = 0.50)

In this example, Manager B generated a higher absolute active return (4% vs. 2%). However, Manager A achieved a higher Information Ratio (0.67 vs. 0.50). This indicates that Manager A was more efficient in generating excess returns relative to the active risk taken. While Manager B had a larger outperformance, they also took on significantly more tracking error to achieve it. This highlights how the information ratio helps in understanding the true value added by a manager, beyond just gross returns.

Practical Applications

The Information Ratio is a versatile tool with several practical applications in the financial industry:

Manager Selection and Evaluation: Institutional investors and consultants frequently use the information ratio to evaluate and select fund managers. It helps compare managers with different investment styles against their respective benchmarks on a risk-adjusted basis, providing a standardized measure of skill. A consistent and positive information ratio over time can signal a manager's ability to repeatedly generate excess returns for the risks taken.
Performance Attribution: Within asset management firms, the information ratio is used in performance attribution analysis to break down sources of returns and identify whether outperformance or underperformance stems from genuine active decisions or from taking on uncompensated risks.
Investment Policy and Asset Allocation: The information ratio can inform decisions related to asset allocation by helping determine the optimal allocation to various active strategies. It contributes to constructing diversified portfolios that balance potential active returns with acceptable levels of active risk.²
Compensation Structures: In some cases, performance-based compensation for portfolio managers may be tied to achieving certain information ratio targets, incentivizing efficient risk-taking and consistent outperformance.
Risk Budgeting: As part of a broader risk budgeting framework, the information ratio helps allocate "risk capital" efficiently across different active bets within a portfolio.

Limitations and Criticisms

While a powerful metric, the Information Ratio has several limitations and is subject to criticism:

Backward-Looking Nature: Like many performance metrics, the information ratio is calculated using historical data. Past performance is not indicative of future results, and a high historical IR does not guarantee future outperformance.
Benchmark Selection: The choice of benchmark significantly impacts the calculated information ratio. An inappropriate or poorly chosen benchmark can misrepresent a manager's true skill. If a manager's portfolio drifts significantly from its stated benchmark, the IR may become less meaningful.
Time Horizon Sensitivity: The information ratio can be volatile over short periods. A manager might experience a low IR in a given quarter or year due to market fluctuations, even if their long-term process is sound. A short time horizon may not capture the true efficacy of a manager's investment philosophy.
Assumption of Normality: The calculation of tracking error, as a measure of risk, assumes that active returns are normally distributed. In reality, financial returns, especially active returns, can exhibit fat tails or skewness, which may not be fully captured by standard deviation.
Comparison Challenges: Comparing information ratios across managers with vastly different investment universes, strategies, or active risk tolerances can be misleading. An article from the CFA Institute further emphasizes the need to understand the nuances of the information ratio, including the "Fundamental Law of Active Management," to interpret it effectively.¹

Information Ratio vs. Sharpe Ratio

The Information Ratio is often confused with the Sharpe Ratio, as both are popular risk-adjusted return metrics. However, their focus differs significantly.

Feature	Information Ratio	Sharpe Ratio
Focus	Active return relative to a benchmark	Total return relative to the risk-free rate
Numerator	(Portfolio Return - Benchmark Return)	(Portfolio Return - Risk-Free Rate)
Denominator	Tracking Error (Standard deviation of active return)	Total Volatility (Standard deviation of total portfolio return)
Interpretation	Measures manager's skill in outperforming benchmark	Measures total risk-adjusted return of a portfolio
Primary Use	Evaluating active managers; relative performance	Evaluating standalone portfolio performance

The core distinction lies in their reference point: the Information Ratio evaluates performance relative to a specific benchmark, making it ideal for assessing active managers, whereas the Sharpe Ratio assesses a portfolio's absolute risk-adjusted return against a theoretical risk-free asset, focusing on the efficiency of the total return generated.

FAQs

What does a "good" Information Ratio look like?

While subjective, an Information Ratio of 0.50 is generally considered good, 0.75 very good, and 1.0 or higher exceptional. These values suggest a manager is generating significant excess returns for the level of active risk they are taking.

Can the Information Ratio be negative?

Yes, the Information Ratio can be negative if the portfolio's return is less than the benchmark's return over the measurement period. A negative IR indicates that the active manager has underperformed the benchmark, adjusted for the active risk taken.

How does Information Ratio relate to active management?

The Information Ratio is a cornerstone of active management evaluation. It quantifies an active manager's success in generating alpha—returns above a benchmark—while considering the consistency of those returns relative to the active risks assumed. It helps determine if outperformance is due to skill or merely higher risk-taking.

Is the Information Ratio better than the Sharpe Ratio?

Neither is inherently "better"; they serve different purposes. The Information Ratio is superior for evaluating active managers relative to a specific benchmark, providing insight into their skill in generating relative outperformance. The Sharpe Ratio is better for assessing the overall risk-adjusted return of a standalone portfolio against a risk-free rate, without explicit reference to a benchmark. Investors should use both depending on their analytical objective.

What is the Information Coefficient (IC) in relation to the Information Ratio?

The Information Coefficient (IC) is a measure of a manager's skill in forecasting security returns. According to the "Fundamental Law of Active Management" proposed by Grinold and Kahn, the Information Ratio is proportional to the product of the IC and the square root of "breadth" (the number of independent bets or decisions made by the manager). This theoretical relationship highlights how a manager's predictive ability and the frequency of applying that ability contribute to their overall Information Ratio and ultimately, their capacity for diversification.