Definition and Formula
The Information Ratio (IR) equals the annualized excess return of a portfolio over its benchmark divided by the annualized standard deviation of that excess return (tracking error). Mathematically: IR = (R_portfolio - R_benchmark) / Tracking Error. If a fund returns 12% annually while its benchmark returns 10%, and the tracking error is 4%, the IR is (12% - 10%) / 4% = 0.50. This single number captures both the magnitude of outperformance and the consistency with which it is delivered.
How It Differs from the Sharpe Ratio
The Sharpe ratio measures total risk-adjusted return relative to the risk-free rate, while the Information Ratio measures active risk-adjusted return relative to a benchmark. A fund with a high Sharpe ratio might simply be riding a bull market. The IR is therefore suited to evaluating whether an active manager justifies their higher fees.
A Worked Example
With the same 2% excess return, a tracking error of 8% instead of 4% halves the IR to 0.25.
How Institutional Investors Use the Information Ratio
Large institutional investors use the IR to allocate their active risk budget across managers. If a pension fund has a total tracking error budget of 3%, it might allocate 1.5% to a high-IR equity manager and 1.5% to a high-IR fixed-income manager, rather than concentrating all active risk in one area.
Tips for Individual Investors
If a fund fact sheet does not display the Information Ratio directly, you can approximate it using the fund's alpha (excess return over benchmark) and tracking error. A high IR in the past does not guarantee future performance.