Question

Why does the Information Ratio use the tracking error instead of the total portfolio standard deviation when measuring a manager&#x27;s skill against a benchmark?

Accepted Answer

The Information Ratio measures how much extra return a manager earns for the amount of risk they take compared to a benchmark, which is just a standard market index like the S&P 500 used for comparison. We use tracking error instead of total standard deviation because we want to isolate the manager&#x27;s personal decisions from the general movement of the market. Tracking error is simply the volatility of the difference between the manager&#x27;s returns and the benchmark&#x27;s returns. If you used the total standard deviation, you would be including the risk of the whole market, which the manager cannot control. Imagine a runner trying to beat a world record; the total standard deviation is like measuring the runner&#x27;s speed while they are on a moving sidewalk, while the tracking error measures how much faster or slower they are running than the sidewalk itself. By focusing on tracking error, the Information Ratio tells you if the manager is actually adding value through their own choices or if they are just lucky because the entire market went up.

Why does the Information Ratio use the tracking error instead of the total portfolio standard deviation when measuring a manager's skill against a benchmark?

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Why does the Information Ratio use the tracking error instead of the total portfolio standard deviation when measuring a manager's skill against a benchmark?

Community Answers