The information ratio is one component of the Fundamental Law of Active management and is a measure of risk adjusted returns relative to a stated benchmark.
The Information Ratio can be calculated using the following formula:
where:
Let’s assume an investor wants to compare two large cap value managers. Manager A & B’s portfolios have the following characteristics:
| Manager A | Manager B | Benchmark | |
| Return | 8.00% | 9.00% | 7.00% |
| Std Dev | 11.00% | 13.00% | 10.00% |
Given the numbers above, let’s calculate the information ratio for Manager A:
Next, we’ll calculate the information ratio for Manager B:
On the surface, it would appear that Manager B’s portfolio is superior to Manager A’s portfolio based solely on the absolute level of investment returns; however, Manager A’s portfolio is superior if looking at absolute returns on a risk adjusted basis.
Since Manager A’s information ratio of 1.00 is greater than Manager B’s information ratio of 0.667, we can make the determination that Manager A has better risk adjusted returns, all else being equal, since both of these managers are creating portfolios with a large cap value mandate and their returns are adjusted using the same benchmark.
Generally speaking, information ratios near one are good, above one are great, and above zero are passable. It is important to note, that no information can be gleaned from information ratios that are negative.
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