The information ratio (IR) measures the consistency and skill of active portfolio management by comparing the portfolio's active return (excess return over a benchmark) to the tracking error (the standard deviation of those active returns). The formula is: IR = (Rp - Rb) / Tracking Error, where Rp is the portfolio return and Rb is the benchmark return. A higher IR indicates more consistent outperformance per unit of active risk.

The information ratio is considered one of the most important metrics for evaluating actively managed funds. While a fund may occasionally beat its benchmark, the IR captures whether that outperformance is consistent or just due to taking large, risky bets. An IR of 0.5 is generally considered good, 0.75 is very good, and above 1.0 is exceptional. Most active managers struggle to maintain an IR above 0.5 over extended periods, which partly explains the growth of passive investing.

For example, a portfolio returning 11% against a benchmark returning 9% with a tracking error of 4% has an information ratio of 0.50. This means the manager earns 0.50 units of active return for each unit of tracking error. The IR helps investors distinguish between managers who outperform through skill versus those who outperform by simply taking on more risk or making concentrated bets that may not be repeatable.