Information Ratio and Tracking ErrorIR
Tracking error is the volatility of the difference between a portfolio’s returns and its benchmark’s. The information ratio divides the average excess return by the tracking error, showing how consistently a manager beats the benchmark.
Beating a benchmark once is easy; beating it steadily is hard. Tracking error measures how much a portfolio's returns wander from its benchmark, and the information ratio divides the average excess return by that wander. Together they show whether outperformance is consistent or just noise.
- Reading time
- 3 min
- Also called
- IR, Tracking error, Active risk
- Updated
The information ratio in plain words
The information ratio shows how much extra return over the benchmark a manager earned for each unit of extra risk taken against it.1
The excess return is called active return, and its variability is called active risk, tracking risk or tracking error.1
A higher reading usually means the outperformance came efficiently; a low or negative one can mean risk taken without reward.2
How to calculate it
Choose a benchmark
Pick a benchmark that genuinely matches the strategy — everything else depends on it.2
Collect period returns
Use the same periods for portfolio and benchmark.
Compute active returns
Subtract benchmark return from portfolio return each period.
Compute tracking error
Take the standard deviation of those active returns.
Divide
Divide the average active return by the tracking error.2
Annualise and compare
Compare only over the same time window and benchmark.
Worked examples
Example 1 — Steady outperformer
IR 0.5A hypothetical portfolio beats its benchmark by +2% a year with 4% tracking error.
| Active return | +2% |
| Tracking error | 4% |
| Information ratio | 0.5 |
Excess return relative to excess risk is moderate and fairly consistent.1
Example 2 — Noisy outperformer
IR 0.125A hypothetical portfolio beats by +2% a year but with 16% tracking error.
| Active return | +2% |
| Tracking error | 16% |
| Information ratio | 0.125 |
A low reading can point to risk without reward, so the same excess return is far less convincing.2
Example 3 — Underperformer
IR −0.2A hypothetical portfolio trails its benchmark by −1% a year with 5% tracking error.
| Active return | −1% |
| Information ratio | −0.2 |
A negative reading shows risk without reward against this benchmark.2
Information ratio vs Sharpe ratio
| Aspect | Information ratio | Sharpe ratio |
|---|---|---|
| Compared with | A benchmark | Risk-free rate |
| Risk measure | Tracking error | Total volatility |
| Answers | Consistent benchmark beating? | Return per unit of risk? |
| Best for | Active managers, index-relative strategies | Any portfolio |
Where it is used
Fund selection
Comparing active funds against the same index.
Strategy review
Checking a Trading Strategy against a buy-and-hold benchmark.
Risk budgets
Setting tracking error limits for managers.
Index tracking
Low tracking error for an Exchange-Traded Fund.
Advantages and disadvantages
Advantages
- Rewards consistency, not one lucky year.
- Uses a relevant benchmark.
- Separates active risk from market risk.
- Widely used by professionals.
Disadvantages
- Depends heavily on the benchmark.
- Depends on the time window.
- Does not explain how returns were made.
- Short histories are unreliable.
Going deeper
Read as far as you need. Each level builds on the one before it.
Tracking error
Beginner
Index funds and ETFs that copy major indices usually have low tracking error; a high figure means returns can stray far from the benchmark, up or down.3
Sensitivity
Intermediate
The result depends heavily on which period you measure and which benchmark you choose.1
Limits
Advanced
It tells you whether a manager beat the benchmark after adjusting for risk, but not how they did it.1 Pair it with Drawdown and the Sharpe Ratio.
Common mistakes
Wrong benchmark
A mismatched index makes the ratio meaningless.
Cherry-picked window
Choosing flattering dates.
Too few periods
Small samples are noisy.
Confusing with Sharpe
Different risk measure.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Tracking error is active risk.
- IR = active return ÷ tracking error.
- Higher means more consistent outperformance.
- Benchmark choice is critical.
- Compare like-for-like periods.
Frequently asked questions
What is a good information ratio?
Can tracking error be zero?
Is it useful for traders?
Further learning
- Sharpe Ratio
The risk-free comparison.
- Volatility
How risk is measured.
- Beta
Market sensitivity.
- Exchange-Traded Fund
Low tracking error funds.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- CFA Institute. The Sharpe Ratio and the Information Ratio (opens in a new tab) Checked .
- Charles Schwab. What's the Information Ratio? (opens in a new tab) Checked .
- Corporate Finance Institute. Tracking Error (opens in a new tab) Checked .
Read more elsewhere
- Trading Metrics (our sister site): Information Ratio (opens in a new tab)
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. Trading Metrics is our sister site, under the same ownership; we are not affiliated with any other publisher linked above. Last reviewed . Report an error or request a source credit.