How is the Information Ratio (IR) calculated?

The Information Ratio (IR) is designed to measure the efficiency of a portfolio manager in generating excess returns relative to a benchmark, taking into consideration the risk of being different from that benchmark. The correct formulation for calculating the Information Ratio is to divide the expected active return (the return of the portfolio above the benchmark) by the tracking risk (which is the standard deviation of the active return).

In this context, expected active return is the anticipated return that the portfolio will yield over the benchmark. Tracking risk reflects how much the returns of the portfolio deviate from the benchmark, serving as a measure of risk associated specifically with the active investment decisions relative to the benchmark.

The effectiveness of a portfolio manager can be evaluated by this ratio: a higher Information Ratio indicates a more favorable risk-adjusted return. By using the active return and tracking risk in the calculation, investors can assess how well a manager is compensating for the risk taken in pursuing returns that deviate from the index.

Other options do not correctly represent the formula or purpose of the Information Ratio. For instance, calculating using expected return over the risk-free rate or merely using tracking error does not capture the essence of the Information Ratio, which is focused on the relationship between the active return specifically and the risk