Information Ratio: How to Measure a Portfolio Manager's Skill

How to Calculate the Information Ratio

The information ratio calculation has two components: active return and tracking error. Active return is the difference between the portfolio's return and the benchmark's return over a given period. Tracking error is the standard deviation of those active returns — it measures how consistently the manager beats (or trails) the benchmark. For example, a manager who outperforms by 0.5% every month has low tracking error but steady outperformance. A manager who beats by 5% in some months and trails by 4% in others has the same average active return but much higher tracking error. To calculate: take the portfolio's monthly returns, subtract the benchmark's monthly returns to get the active returns, calculate the annualized standard deviation of those active returns (tracking error), and divide the annualized active return by the tracking error. A manager with 2% annualized active return and 4% tracking error has an IR of 0.5. The same active return with 2% tracking error yields an IR of 1.0. Understanding volatility and standard deviation →

What Different Information Ratios Mean

The information ratio has well-established empirical benchmarks. An IR of 0.50 is considered average — the manager is adding value but not enough to be statistically confident that skill is involved. An IR of 0.75 is good — there is reasonable evidence of skill. An IR of 1.00 is very good — the manager is generating one unit of active return for each unit of active risk, which is the threshold for most institutional mandates. An IR of 1.50 is exceptional — fewer than 5% of active managers sustain this over long periods. The most elite managers in the world (Renaissance Technologies, some quantitative hedge funds) have achieved IRs above 2.0, but these are extremely rare and often in less efficient markets. Crucially, the information ratio mean-reverts over time — managers with very high IRs tend to regress toward 0.5-0.75 as assets under management grow and opportunities shrink. Academic research suggests that the average active manager has an information ratio near zero after fees, consistent with efficient market theory. Active vs passive: can managers consistently add value? →

Information Ratio vs Sharpe Ratio

The information ratio and Sharpe ratio are often confused but measure fundamentally different things. The Sharpe ratio measures total excess return (above the risk-free rate) per unit of total volatility — it evaluates the absolute risk-adjusted performance of the entire portfolio. The information ratio measures active excess return (above the benchmark) per unit of tracking error — it evaluates only the active management component, ignoring the benchmark return. A passive index fund has a Sharpe ratio equal to the market's but an information ratio of zero (no active return). An active fund can have a lower Sharpe ratio than the index (due to higher total volatility) but a positive information ratio (adding value vs its benchmark). In practice: the Sharpe ratio tells you if a portfolio is efficient in absolute terms, while the information ratio tells you if the manager's active decisions are adding value relative to the risk taken. Institutional investors use both: the Sharpe ratio for asset allocation and the information ratio for manager selection. All risk-adjusted return metrics compared →

Limitations of the Information Ratio

The information ratio has several important limitations. First, it assumes the benchmark is appropriate — a manager can appear to have a high IR simply by being measured against the wrong benchmark. A small-cap manager measured against the S&P 500 will have a high tracking error and potentially misleading IR. Second, the information ratio requires sufficient data to be meaningful — at least 3-5 years of monthly data (36-60 observations) for statistical significance. Third, the IR can be manipulated through benchmark selection, return smoothing, or trading strategies that hide tracking error (such as holding the benchmark and making small, infrequent active bets). Fourth, the information ratio does not capture the economic significance of the active return — a manager with IR of 1.0 but only 0.5% active return is adding less value than one with IR of 0.75 but 3% active return. Fifth, like all risk-adjusted metrics, the IR assumes normally distributed active returns, which may not hold for strategies with non-linear exposures or tail risk. Despite these limitations, the information ratio remains the industry standard for evaluating active management skill. Factor investing: separating alpha from factor exposure →

What is a good information ratio for a fund manager?

An information ratio of 0.50 is considered average for active managers. An IR of 0.75 is good and suggests genuine skill. An IR of 1.00 is very good — only about 10-15% of active managers achieve this over 5+ years. An IR of 1.50 is exceptional and typically only found in less efficient markets (small-cap, emerging markets) or specialized quantitative strategies. For institutional investors, a minimum IR of 0.50-0.75 is typically required before hiring a manager, and an IR above 1.00 is considered strong enough to justify significant allocation. Importantly, the information ratio should be evaluated net of fees — a manager with gross IR of 1.0 but 1% management fee may have a net IR of only 0.5. When evaluating fund managers, always use net-of-fee returns and compare against peer managers in the same asset class and style category. How to research and evaluate fund managers →

How does tracking error affect the information ratio?

Tracking error directly determines the information ratio for a given level of active return. A manager who generates 2% active return with 2% tracking error has IR of 1.0. If the same manager tries to generate 2% active return with 4% tracking error, the IR drops to 0.5. Lower tracking error means more consistent outperformance, which increases confidence that the alpha is driven by skill rather than luck. However, very low tracking error (below 1-2%) makes it mathematically difficult to achieve a high IR because the active return must also be very small. The relationship between active return and tracking error defines the manager's information coefficient — essentially, how good the manager is at forecasting returns. Managers with high information coefficients can generate high active returns with low tracking error, resulting in exceptional IRs. The key trade-off: increasing tracking error (making bigger active bets) can increase active return but may not improve the IR if the bets are not sufficiently informed. Position sizing and risk budgeting →

What is the fundamental law of active management?

The fundamental law of active management, developed by Richard Grinold and Ronald Kahn, states that a manager's information ratio is approximately equal to their information coefficient (IC) times the square root of their breadth (number of independent active bets per year). The formula is: IR = IC x sqrt(breadth). The information coefficient measures the manager's forecasting ability — the correlation between their return forecasts and actual returns. Breadth is the number of independent active decisions the manager makes per year. This framework explains why quantitative managers with moderate IC but very high breadth (thousands of bets per year) can achieve high IRs, while fundamental managers with high IC but low breadth (10-20 concentrated bets per year) need exceptional forecasting skill to achieve the same IR. The fundamental law implies that to double the IR, a manager must either double their IC (forecasting skill, very difficult) or quadruple their breadth (make four times as many independent bets, often more feasible). Quantitative approaches to investing →

Can the information ratio be negative?

Yes. A negative information ratio means the manager is underperforming the benchmark after adjusting for active risk. A manager with -1% active return and 4% tracking error has an IR of -0.25 — the manager is losing money relative to the benchmark with meaningful tracking error, which is a strong negative signal. However, a negative IR can also arise from a manager who is deliberately taking less risk than the benchmark (a defensive posture in anticipation of a market decline). In this case, the negative active return is expected if the manager's market timing is wrong. The information ratio should always be evaluated in the context of the manager's investment strategy and market environment. A value manager may have negative IR during growth-led bull markets but positive IR over full market cycles. As with all performance metrics, evaluate the IR over complete market cycles (5+ years) rather than short periods. Behavioral biases in evaluating manager performance →

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