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, whereas a high IR specifically indicates skill in beating the benchmark. For an index fund, the IR is essentially zero (no excess return, minimal tracking error). The IR is therefore the metric of choice when evaluating whether an active manager justifies their higher fees.
Practical Benchmarks for Evaluation
In the institutional investment world, an IR of 0.50 is considered good, 0.75 is very good, and 1.0 or above is exceptional and rarely sustained over long periods. Research by Grinold and Kahn suggests that fewer than 10% of active managers maintain an IR above 0.50 over a rolling 5-year window. An IR below 0.20 generally indicates that the manager's outperformance is indistinguishable from noise. Pension funds and endowments typically require a minimum IR of 0.30-0.40 before allocating to an active strategy.
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. The IR also helps determine how much capital to allocate: a manager with an IR of 0.80 deserves a larger allocation than one with an IR of 0.30, because each unit of tracking error produces more excess return. Portfolio management textbooks cover the IR framework comprehensively
Tips for Individual Investors
Most fund fact sheets do not display the Information Ratio directly, but you can approximate it using the fund's alpha (excess return over benchmark) and tracking error, both of which are commonly reported. When comparing two active funds in the same category, prefer the one with the higher IR even if its raw return is lower, because it delivers outperformance more consistently. Remember that a high IR in the past does not guarantee future performance, but it is a stronger signal of skill than raw returns alone. If no active fund in a category shows an IR above 0.30 over 5 years, you are almost certainly better off with a low-cost index fund.