What Is the Information Ratio and How to Interpret It?
The information ratio measures whether a manager beats their reference index with enough consistency to make paying for active management worthwhile. It does not simply compare returns: it adjusts the excess return for the risk the manager takes on by deviating from the benchmark. That is why it is one of the favorite metrics among professional analysts and one of the first things worth checking before choosing an actively managed investment fund.
What is the information ratio and what is it for?
The information ratio is the quotient between a fund's excess return over its reference index and its tracking error. In one sentence: how much extra return the manager earns for each unit of risk taken by deviating from the benchmark.
Its main use is separating skill from luck. A fund can beat its index in any given year thanks to one lucky bet; if it beats it repeatedly and with controlled deviations, it is more likely that there is a solid process behind it. That is why it is used above all to evaluate actively managed funds, where you pay a higher fee in exchange for the attempt to do better than the market.
The information ratio formula explained step by step
The formula is simple:
Information ratio = (Fund return − Benchmark return) ÷ Tracking error
Let's break it down:
- Numerator (excess return): this is the difference between what the fund has returned and what its reference index has returned over the same period. If the fund gains 10% and the index 8%, the excess is 2 percentage points. This excess is also known as active return.
- Denominator (tracking error): this is the standard deviation of those return differences over time. It measures regularity: a low tracking error indicates that the fund behaves very much like its index; a high one, that the manager takes very different positions and their results swing widely relative to the benchmark.
The intuition: it is not enough to beat the index — you have to beat it without wild swings. Two funds with the same excess return can have very different ratios if one achieves it steadily and the other through brilliant years followed by disastrous ones.
How do you interpret the information ratio?
The higher, the better. As a reference, the classic financial literature (Grinold and Kahn) usually works with these indicative ranges:
| Information ratio | Reading |
|---|---|
| Negative | The fund does worse than its index on a risk-adjusted basis. Active management is destroying value. |
| Between 0 and 0.5 | Beats the index, but with little consistency. A modest result. |
| Between 0.5 and 0.75 | Good. The manager generates value with reasonable stability. |
| Between 0.75 and 1 | Very good. Few funds sustain this over long periods. |
| Above 1 | Excellent. Exceptional if maintained over 5 or 10 years. |
Two caveats. First, the time frame: calculated over a single year it says very little; what matters is looking at 3, 5 or 10 years. Second, it only makes sense to compare funds in the same category and with the same reference index.
A numerical example: two funds against the same index
Imagine you have €100,000 and are deciding between two global equity funds that use the same benchmark, an index that has returned an average of 8% a year over the last five years:
- Fund A: average annual return of 12%, with a tracking error of 8%. Its excess return is 4 points (12% − 8%) and its information ratio is 4 ÷ 8 = 0.5.
- Fund B: average annual return of 10%, with a tracking error of 1.6%. Its excess is 2 points (10% − 8%) and its information ratio is 2 ÷ 1.6 = 1.25.
In euro terms, in an average year Fund A would have turned your €100,000 into €112,000 and Fund B into €110,000, compared with €108,000 for the index. At first glance, Fund A wins. But the ratio tells a different story: Fund A achieves its average by alternating years in which it beats the index by 12 points with years in which it loses by 4, while Fund B beats it by around 2 points almost every year.
Fund B has a much higher information ratio because its excess return is far more reliable. For a long-term investor, that consistency points to a repeatable process and reduces the risk of buying in just before one of the manager's bad years.
Information ratio vs Sharpe ratio and other metrics
The information ratio belongs to the family of risk-adjusted return metrics, but each one answers a different question:
| Metric | Compares the fund with… | Risk it uses | Question it answers |
|---|---|---|---|
| Information ratio | Its reference index | Tracking error | Does the manager beat their benchmark with consistency? |
| Sharpe ratio | The risk-free asset | Total volatility | Does the return compensate for the total risk taken? |
| Jensen's alpha | What its beta would predict | Market risk (beta) | How much extra return does the manager generate after stripping out the market? |
The Sharpe ratio measures return per unit of total risk and can be used to compare almost any investment against another. The information ratio, by contrast, is specific to active management: it only makes sense when there is a clear benchmark to beat. For its part, Jensen's alpha measures the value added by the manager once you strip out what the market itself explains. The three metrics complement each other, and in practice it pays to look at them together: we explain how to combine them in our guide on how to use the Sharpe ratio and the information ratio.
Limitations you should know about
Like any metric, the information ratio has blind spots:
- It depends on the chosen benchmark. If the reference index does not properly reflect the fund's investment universe, the ratio is distorted from the start.
- It looks backwards. A good historical ratio does not ensure the manager will keep getting it right: teams change and styles stop working, and either can break the streak.
- It can reward closet trackers. A fund that barely deviates from the index can show a decent ratio with a negligible excess return. It is worth looking at the numerator and the denominator separately.
- It is sensitive to the period. The same fund can go from a brilliant ratio to a mediocre one depending on the time window. Use long periods and, if you can, several of them.
How we approach this at Quality Finance
At Quality Finance we use the information ratio alongside other quantitative and qualitative metrics to select funds within an open architecture model: we analyze fund managers from across the whole market and choose the ones that fit each client's objectives, time horizon and risk tolerance. No ratio is a substitute for sound wealth planning, but knowing how to read them makes the difference between choosing a fund for its latest stellar year and choosing it for the strength of its process. If you would like us to review the quality of the funds in your portfolio with you, we will be glad to help.
Frequently asked questions
What is considered a good information ratio?
As a general reference, from 0.5 upwards is considered good, above 0.75 very good, and above 1 excellent. The truly hard part is sustaining those levels over 5 or 10 years, so always look at long periods.
How does the information ratio differ from the Sharpe ratio?
The Sharpe ratio compares the fund with the risk-free asset using total volatility; the information ratio compares it with its benchmark using tracking error. The first evaluates the investment itself; the second, the manager's skill.
Where can I find a fund's information ratio?
It usually appears in the fund's monthly factsheet, in the fund manager's reports and on fund analysis platforms. You can also calculate it yourself using the returns of the fund and its index.
Does the information ratio make sense for an index fund?
Not really. An index fund aims to replicate its index, so its tracking error tends towards zero and its excess return is slightly negative because of fees. The information ratio is designed to evaluate active management, not passive replication.
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