The Information Ratio quantifies how reliably a portfolio generates active return (alpha) relative to its benchmark:
IR = Annualized Active Return / Annualized Tracking Error
where active return is the portfolio return minus the benchmark return, and tracking error is the standard deviation of that difference. An IR of 0.5 or above is generally considered strong for a diversified active strategy, though this benchmark varies by asset class and strategy type.
IR vs Sharpe Ratio
The Sharpe Ratio measures return per unit of total risk. The IR measures return per unit of active (benchmark-relative) risk. For a market-neutral long-short strategy where the benchmark is cash, the two ratios are equivalent. For long-only strategies with a market benchmark, the IR more precisely captures active skill after accounting for market exposure.
Fundamental Law connection
The Fundamental Law of Active Management decomposes IR into its drivers: IR ≈ IC × TC × √N. This framework shows that high IR requires either exceptional signal skill (IC), efficient implementation (TC), or high breadth (N) — or some combination of all three.