# Information Ratio and Tracking Error

> The information ratio divides active return by tracking error to measure how consistently a portfolio beats its benchmark. Learn the formulas, values and uses.

Source: https://learn.tradelabsai.com/portfolio/information-ratio/  
Track: Portfolio and Performance · Level: Intermediate · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "Information Ratio and Tracking Error", https://learn.tradelabsai.com/portfolio/information-ratio/

Most professional investors are judged against a benchmark, such as the S&P 500 for a US equity fund. Two numbers describe that relationship. Tracking error measures how much the portfolio's returns differ from the benchmark's. The information ratio divides the average excess return over the benchmark, called active return, by tracking error. It answers a key question: how much extra return does the manager earn for each unit of risk taken in departing from the benchmark?

## The formulas

```
Active return = Portfolio return - Benchmark return
Tracking error = Standard deviation of active returns (annualised)
Information ratio = Average active return / Tracking error
```

**Example: Calculating the information ratio**
A fund returns an average of 11% a year while its benchmark returns 9%, an active return of 2%. The standard deviation of the yearly differences between the fund and the benchmark is 4%, the tracking error. The information ratio is 2 divided by 4, or 0.5. Another fund with active return of 1% and tracking error of 1.5% has an information ratio of about 0.67. The second fund beats its benchmark by less, but far more consistently.

## Tracking error levels

| Tracking error | Typical portfolio |
|---|---|
| Below 1% | Index funds and enhanced index funds |
| 1% to 3% | Benchmark aware active funds |
| 3% to 6% | Typical active equity funds |
| Above 6% | Concentrated or unconstrained strategies |

Index funds aim for tracking error close to zero. Active managers take tracking error deliberately, hoping to earn active return. See [Active vs Passive Investing](https://learn.tradelabsai.com/portfolio/active-vs-passive-investing/).

## What is a good information ratio?

| Information ratio | Rough interpretation |
|---|---|
| Below 0 | Underperforming the benchmark |
| 0 to 0.3 | Modest |
| 0.3 to 0.5 | Good |
| 0.5 to 1.0 | Very good |
| Above 1.0 | Exceptional, and rare over long periods |

Sustained information ratios above 0.5 are uncommon among active managers, especially after fees.

## The fundamental law of active management

Richard Grinold proposed a link between skill, breadth and the information ratio:

```
Information ratio ≈ Information coefficient × Square root of Breadth
```

- **Information coefficient (IC):** the correlation between forecasts and outcomes, a measure of skill.
- **Breadth:** the number of independent bets per year.

A small edge applied to many independent bets can produce a strong information ratio. An IC of 0.05 across 400 independent bets a year gives an information ratio of about 0.05 times 20, or 1.0. In practice, bets are rarely fully independent, so real breadth is smaller than the raw count. This logic underlies many quantitative strategies. See [Quantitative Trading](https://learn.tradelabsai.com/strategies/quantitative-trading/) and [Combining Signals](https://learn.tradelabsai.com/research/combining-signals/).

## Information ratio versus Sharpe ratio

| | Sharpe ratio | Information ratio |
|---|---|---|
| Compares with | Risk free rate | A benchmark |
| Risk measure | Total volatility | Tracking error |
| Best for | Absolute return strategies | Benchmark relative portfolios |

For a market neutral fund with a cash benchmark, the two are nearly the same. See [Sharpe Ratio](https://learn.tradelabsai.com/portfolio/sharpe-ratio/).

## Pitfalls

1. **Wrong benchmark:** a fund holding small stocks measured against a large cap index shows misleading active returns.
2. **Short periods:** active returns are noisy; several years are needed. See [Statistical Significance in Trading](https://learn.tradelabsai.com/math/statistical-significance/).
3. **Closet indexing:** very low tracking error with fees produces a negative information ratio.
4. **Hidden factor bets:** active return may come from factor exposures rather than skill. See [Factor Models](https://learn.tradelabsai.com/portfolio/factor-models/) and [P&L and Performance Attribution](https://learn.tradelabsai.com/industry/performance-attribution/).

## Information ratio for your own trading

Individual traders can use the same idea by choosing a benchmark that matches what they could have earned passively, such as a broad index fund for a stock trader or simply holding Bitcoin for a crypto trader. Compute your monthly returns minus the benchmark's, then the average and standard deviation of those differences. If your active return is small relative to its variability, trading actively may not be worth the time, costs and stress compared with the passive alternative. See [Investing vs Trading](https://learn.tradelabsai.com/start-here/investing-vs-trading/).

## Frequently asked questions

### What is the information ratio?

Active return over a benchmark divided by tracking error, measuring how much excess return a portfolio earns per unit of benchmark relative risk.

### What is tracking error?

The standard deviation of the difference between a portfolio's returns and its benchmark's returns.

### What is a good information ratio?

Above 0.5 sustained over several years is considered very good; above 1.0 is rare.

Next, learn a ratio that measures return per unit of market risk in [Treynor Ratio](https://learn.tradelabsai.com/portfolio/treynor-ratio/).

## Continue learning

- Next lesson: [Treynor Ratio](https://learn.tradelabsai.com/portfolio/treynor-ratio/)
- Previous lesson: [Alpha and Beta](https://learn.tradelabsai.com/portfolio/alpha-and-beta/)
- Related: [Alpha and Beta](https://learn.tradelabsai.com/portfolio/alpha-and-beta/): Beta measures how much a portfolio moves with the market; alpha is the return beyond what that exposure explains. Learn formulas, CAPM, regression and pitfalls.
- Related: [Sharpe Ratio](https://learn.tradelabsai.com/portfolio/sharpe-ratio/): The Sharpe ratio measures return per unit of risk. Learn the formula, how to annualise it, what counts as a good Sharpe ratio, its limitations and common mistakes.
- Related: [Active vs Passive Investing](https://learn.tradelabsai.com/portfolio/active-vs-passive-investing/): Active investing tries to beat the market; passive investing tracks it at low cost. Learn the evidence on performance, the impact of fees and how to choose.
- Related: [P&L and Performance Attribution](https://learn.tradelabsai.com/industry/performance-attribution/): Performance attribution explains where returns came from: allocation, selection, factors, Greeks and costs. Learn Brinson attribution, P&L explain and how to use it.
- Related: [Treynor Ratio](https://learn.tradelabsai.com/portfolio/treynor-ratio/): The Treynor ratio divides excess return by beta to measure reward for market risk. Learn the formula, a worked comparison and how it differs from the Sharpe ratio.