Work out the information ratio on both an ex post and an ex ante basis, explain what it means, and contrast it with the Sharpe ratio
The idea
The information ratio divides active return by active risk. Ex post it is the mean realised active return over a period divided by the standard deviation of those active returns, the tracking error; ex ante it is expected active return divided by expected active risk. The Sharpe ratio instead divides return in excess of the risk-free rate by total volatility, so it rewards total risk-taking, not skill relative to a benchmark. Both ratios are unaffected by scaling: mixing an active fund with its benchmark scales active return and active risk together, just as mixing a portfolio with cash scales excess return and volatility. The trap is dividing active return by total volatility rather than by tracking error.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Explain how the value that active management adds is gauged
- Set out and explain the fundamental law of active management for portfolios and each of its terms: breadth, the information coefficient, the transfer coefficient, and active risk (aggressiveness)
- Explain how the information ratio can help in picking investment managers and in deciding how much active risk a portfolio should carry
- Contrast active strategies such as security selection and market timing, and use active management's fundamental law to assess shifts in strategy
- Set out where active management's fundamental law is useful in practice and where it falls short