A Fund That Beat Its Benchmark by 8% Once and One That Beat It by 2% for Five Years Straight Aren't Equally Impressive. Information Ratio Is Why
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5 min read
Picture two funds. Fund X beat its benchmark by 8% in one spectacular year, then lagged behind it for three of the next four. Fund Y never had a spectacular year. It just beat its benchmark by around 2% a year, five years running. Which one is the better active manager? The information ratio is the number built to answer exactly that question, and it does not agree with your gut.
The information ratio divides a portfolio's active return, how much it beat its benchmark by, by its tracking error, how much that gap bounces around from period to period.
(Portfolio return − Benchmark return) ÷ Tracking error
Active return is the easy half. Take what the portfolio actually returned, subtract what the benchmark returned over the same period, and that gap is the active return.
Tracking error is the part that changes everything. It is the standard deviation of that gap across many periods, usually years. A manager whose active return is +2% almost every single year has a small tracking error. A manager whose active return swings from +8% to -3% to +6% has a large one, even if the average comes out the same.
That is the whole point of the ratio. Two managers can post an identical average active return and still earn very different information ratios, because the ratio is really scoring how repeatable the outperformance looks, not how big it was in any one year.
The information ratio, and the reasoning behind why consistency should count as much as it does, comes from Richard Grinold and Ronald Kahn's 1994 book Active Portfolio Management, later formalised as the "fundamental law of active management." Their argument was that a manager's real skill, the information coefficient, only shows up reliably once you also account for how often that skill gets a chance to act, the breadth of independent decisions made over time. A manager who gets one big call right once a year is harder to trust than one who gets a smaller call right many times over, and the information ratio is the number that rewards the second kind of manager.
Here are five years of active return, the fund's return minus its benchmark's return, for each fund.
| Fund X | Fund Y | |
|---|---|---|
| Year 1 | +8% | +3% |
| Year 2 | -2% | +1% |
| Year 3 | +1% | +2.5% |
| Year 4 | -3% | +1.5% |
| Year 5 | +6% | +2% |
| Average active return | 2.0% | 2.0% |
| Tracking error | 4.8% | 0.8% |
| Information ratio | 0.41 | 2.53 |
Both funds beat their benchmark by exactly the same amount on average: 2% a year. A return chart of five-year cumulative performance would look almost identical. But Fund X got there with one huge year doing most of the work and two losing years dragging it back, while Fund Y's active return barely moved from one year to the next. Dividing by that much smaller tracking error is what pushes Fund Y's information ratio more than six times higher than Fund X's.
There is no single official cutoff, but fund evaluators and institutional consultants tend to work with bands like these.
Below 0.4. Unremarkable. The active return has not been reliable enough, relative to how much it swings, to call it skill rather than noise.
Between 0.4 and 1.0. Solid to strong. Widely treated as evidence of real, repeatable manager skill, with the top of that range considered a very good result.
Above 1.0. Rare. Most funds that hold this for a full market cycle, not just one lucky stretch, are considered exceptional active managers.
An information ratio needs several years of data before it means much. A single great year, or a single bad one, can move it sharply, which is exactly the trap the ratio exists to protect against when it is read over the right time frame.
The information ratio is only as good as the benchmark it is measured against. Compare a fund to a benchmark it does not actually resemble, and the "active return" it reports is partly just the fund doing something completely different, not skill. Always check that the benchmark is one the fund is actually trying to beat, not a convenient index picked after the fact.
It also inherits the same backward-looking limit every risk-adjusted ratio has. A high information ratio describes what already happened. It says nothing about whether the manager's edge, or their luck, continues from here.
If you hold an actively managed fund, its factsheet or annual report should disclose its benchmark and its historical returns against it. From there, the active return each year is a subtraction, and the tracking error is a standard deviation calculation over those active returns, the same two building blocks behind active weight, which measures how far a fund strays from its benchmark's positions rather than its return.
NetWort tracks your own portfolio's return against a chosen benchmark automatically, the same real-transaction basis behind the Sortino ratio and every other risk metric on your dashboard, so you are never reconstructing active return from a fact sheet by hand.
Open the Portfolio Health section of your dashboard and compare your portfolio's return against a benchmark over several years, not one. The same idea works whichever benchmark you are measuring against, the IHSG, the S&P 500 or a bond index, and you can check how any of them is doing right now on the market overview page. A single good year tells you very little. A long, steady gap is the one worth paying attention to.