The information ratio is the R02 examiner's go-to measure for active manager skill. It tells you how much extra return a manager generated above a benchmark, relative to how much active risk they took on to get it.
The information ratio formula
IR = (R_p − R_b) ÷ Tracking Error
In plain English:
IR = active return ÷ active risk
| Symbol | Meaning |
|---|---|
| R_p | Portfolio (fund) return |
| R_b | Benchmark return (e.g. FTSE All-Share) |
| R_p − R_b | Active return. The manager's outperformance |
| Tracking error | Standard deviation of the active return, how far the manager strayed from the benchmark |
Worked example
Assume:
- Fund return (R_p) = 8%
- Benchmark return (R_b) = 6%
- Tracking error = 4%
Step 1, Active return: 8% − 6% = 2%. Step 2, Divide by tracking error: 2% ÷ 4% = 0.50.
Information ratio = 0.50.
The manager generated 0.5 units of outperformance for every 1 unit of active risk taken, respectable but not exceptional.
How to interpret the result
| Information ratio | What it suggests |
|---|---|
| Above 1.0 | Exceptional, top-quartile active manager |
| 0.5 to 1.0 | Good, genuine skill, worth the fee |
| 0 to 0.5 | Weak, modest outperformance for the active risk taken |
| Negative | Value destruction, investor would have been better off in a tracker |
What R02 actually tests
The exam usually does one of three things:
- Compute the ratio from fund return, benchmark return and tracking error.
- Compare two active funds and pick the one with the higher IR.
- Test understanding of tracking error, for example, why a closet tracker has a low IR even with positive excess return.
Information ratio vs Sharpe ratio
This is the comparison R02 examiners love to test, because the formulas look similar but the inputs are different.
| Sharpe ratio | Information ratio | |
|---|---|---|
| Numerator | R_p − R_f (over risk-free rate) | R_p − R_b (over benchmark) |
| Denominator | σ_p (total risk) | Tracking error (active risk) |
| Measures | Absolute risk-adjusted return | Active manager skill |
| Best for | Whole-portfolio comparison | Comparing active managers vs benchmark |
A passive index tracker can have a high Sharpe ratio but a near-zero information ratio, because it isn't trying to beat the benchmark. Only active funds should be judged on IR.
Common R02 traps
- Using standard deviation instead of tracking error. Tracking error is the σ of the active return (R_p − R_b), not the σ of R_p itself.
- Confusing IR with Sharpe. If the question uses a benchmark, it's information ratio. If it uses the risk-free rate, it's Sharpe.
- Comparing IRs across different benchmarks. A UK equity manager benchmarked to the FTSE 100 and a global equity manager benchmarked to the MSCI World are not directly comparable.
- Ignoring the sign. A negative IR is not just "poor performance". It means the manager actively destroyed value, which has fee implications.
Why R02 cares
Behind the formula is a real-world question that advisers answer every day: is this active fund worth the higher fees, or should the client just buy a tracker? A consistently positive IR over rolling three- or five-year periods is the cleanest evidence that a manager has genuine skill rather than luck.
## Bottom line
The information ratio is one of those R02 topics where remembering one rule, active return over active risk, earns you every available mark. Know the formula, know how it differs from Sharpe, and know what a negative IR means for the client. That's the whole topic.