With mutual funds, the information ratio (IR)--alternatively called the appraisal ratio, measures a portfolio's performance against a specific benchmark, after risk is factored into the equation. The information ratio is determined by calculating the active return (the difference between the portfolio's return and the benchmark's return) and dividing that figure by the tracking error, which measures the degree to which an active manager deviates from the benchmark in question. In addition to indicating the degree to which active managers outperform benchmarks, the IR also reveals the length of time managers are able to outperform those benchmarks.

The information ratio helps investors gauge the success of fund managers, enabling them to make more informed decisions when vetting different investment options. The lower the IR is, the worse a mutual fund's performance is, and the less attractive it becomes. Conversely, a higher information ratio means that an active manager is better qualified to outperform the benchmark and is able to do so for longer durations.

By the Numbers

A negative information ratio signals that a mutual fund was unable to produce any excess returns at all, consequently, investors should eliminate such funds from contention. An information ratio of less than 0.4 means that a mutual fund was unable to produce excess returns for prolonged periods of time, therefore such funds should likewise be avoided. But funds with IR's ranging between 0.4 and 0.6 warrant a closer look, while fund's with IR's between 0.61 and 1 exhibit high return potential, and should be strongly favored by investors.