Believe me, no: I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore my merchandise makes me not sad.
Antonio, in William Shakespeare's "The Merchant of Venice", Act 1, Scene 1.

Like Shakespeare's Antonio, most people understand that it is not in their best interest to put all of their eggs in the same basket. The same people might also agree that the different baskets of eggs should not be placed right next to each other. Unfortunately, investments aren't as simple as a basket of eggs. In this article, we'll show you how the information ratio can help you measure the expected rewards from your investments while monitoring their relative placement in your portfolio.

Background to Modern Portfolio Theory
Today, investors have a wide range of investment choices, which are differentiated by assets class, market capitalization, investment styles, geography etc. Each of these investments has unique return and risk expectations. Let's take a look at two investment choices, A and B, in the efficient frontier chart in Figure 1 along with the combined payoff scenario from holding these investments.

Copyright 2007
Figure 1

If you plot all the investment choices that you have at your disposal (stocks, bonds, portfolios of stocks and bonds) in Figure 1, the resulting chart will be bounded by an upward sloping curve known as the efficient frontier.

The unique reward and risk expectations of investments A and B are shown on the efficient frontier chart in red. One possible payoff from holding investment A and B is shown in green. The interaction between A and B could result in a payoff that is less risky with superior reward. Applying this same diversification concept to multiple investment choices can lead to a superior payoff that approaches the efficient frontier.

In the asset allocation decision process, it is common to use a market proxy or a benchmark that defines a particular investment class. If investment A represents a U.S. large cap equity as defined by the S&P 500, a typical investor can invest in many passive and active portfolios that use the S&P 500 as a benchmark.

A passive strategy mimics the returns of its benchmark, while an active strategy is expected to return some additional returns beyond its benchmark. Thus, a passive strategy can be represented by A and an active strategy will be represented by investments scattered around A.

Copyright 2007
Figure 2

Considering Tracking Error
A statistical dispersion, or an indication of how far away an investment's performance is from its benchmark, is called a tracking error. The tracking error by itself does not indicate whether a portfolio is outperforming or underperforming its benchmark. However, a zero tracking error portfolio will have a risk profile that is identical to its benchmark.

In Figure 2, portfolios on the blue dotted line represent the zero tracking error portfolios. Numerically, a tracking error of 3% indicates that there is a 95% probability that portfolio returns will be within plus or minus 6% of the targeted benchmark.

Why should investors care about tracking error? In order for an assets allocation strategy to work effectively (investment baskets in their general area on the efficient frontier), each of the assets class managers must stay true to his or her stated objectives. A portfolio manager with high tracking error - or one that's too far away from the portfolio's stated benchmark - can become too close to another manger's benchmark, thereby increasing correlation between two assets classes in the same overall portfolio. Higher correlation leads to an inferior overall payoff.

The Information Ratio
The information ratio (IR) is designed to measure how many units of return an investor can achieve over a predefined benchmark for each unit of tracking error risk taken. A common mathematical definition of the information ratio for a portfolio is the excess returns of the portfolio over the predefined benchmark divided by the standard deviation of those excess returns, or the tracking error.

Figure 3

As shown in the formula, the IR will penalize the excess returns by any addition of tracking error risk. The ratio is best used in evaluating portfolio managers of the same asset class with the same benchmark. The information ratio allows the investor to look at a portfolio manager's returns versus his or her peers on a tracking-error-risk-adjusted basis. Going back to our investment choice A (S&P 500 market proxy), a portfolio with the highest IR compared to the S&P 500 will deliver superior rewards compared to the S&P 500 while maintaining all the reward and risk expectation of the S&P 500 and keeping your assets uncorrelated with other investments.

The Bottom Line
There have been many ratios used by proponents of modern portfolio theory, but the information ratio is one of the best for comparing one manager's returns versus his or her peers. Penalizing excess returns because of an addition of tracking error is one of the key reasons why this ratio is gaining popularity among industry professionals and students of portfolio analysis.

Related Articles
  1. Investing

    Five Things to Consider Now for Your 401(k)

    If you can’t stand still, when it comes to checking your 401 (k) balance, focus on these 5 steps to help channel your worries in a more productive manner.
  2. Investing Basics

    Calculating the Margin of Safety

    Buying below the margin of safety minimizes the risk to the investor.
  3. Investing Basics

    Explaining Financial Assets

    A financial asset is intangible property that represents a claim on ownership of an entity or contractual rights to future payments.
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI KLD 400 Social

    Find out about the iShares MSCI KLD 400 Social exchange-traded fund, and learn detailed information about its characteristics, suitability and recommendations.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  9. Mutual Funds & ETFs

    ETF Analysis: Guggenheim BulletShrs 2018 HY CorpBd

    Find out about the Guggenheim BulletShares 2018 High Yield Corporate Bond ETF, and get information about this ETF that focuses on high-yield corporate bonds.
  10. Mutual Funds & ETFs

    ETF Analysis: PowerShares DWA SmallCap Momentum

    Find out about the PowerShares DWA SmallCap Momentum Portfolio ETF, and explore detailed analysis the fund's characteristics, suitability and recommendations.
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Passive Income

    Earnings an individual derives from a rental property, limited ...
  3. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  4. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  5. Net Line

    The amount of risk that an insurance company retains after subtracting ...
  6. Political Risk Insurance

    Coverage that provides financial protection to investors, financial ...
  1. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  2. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  3. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  4. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  5. What percentage of a diversified portfolio should large cap stocks comprise?

    The percentage of a diversified investment portfolio that should consist of large-cap stocks depends on an individual investor's ... Read Full Answer >>
  6. What asset allocation should I use for my retirement portfolio?

    Asset allocation should be personalized to each individual investor's return objectives and risk tolerance. However, there ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!