CFA Level II ExamPortfolio Management and Wealth PlanningMedium
A portfolio manager is evaluating a global equity fund that has consistently outperformed its benchmark over the past five years. However, the fund's active risk (tracking error) has also been relatively high. To assess whether the manager's active returns are justified by the active risk taken, which performance measure would be most appropriate?
- ASharpe Ratio
- BJensen's Alpha
- CInformation Ratio
- DTreynor Measure
Show answer & explanationAnswer & explanation
Correct answer: C. Information Ratio
The Information Ratio (IR) measures the active return (portfolio return minus benchmark return) per unit of active risk (tracking error). It is specifically designed to evaluate the skill of a portfolio manager in generating returns above a benchmark, considering the risks taken to achieve those active returns.
Why the other options are wrong
- A. The Sharpe Ratio measures excess return per unit of total risk, not active risk against a benchmark.
- B. Jensen's Alpha measures the excess return above the CAPM-predicted return, but doesn't explicitly normalize by active risk.
- D. The Treynor Measure measures excess return per unit of systematic risk (beta), not active risk.
Information Ratio (IR)
The Information Ratio (IR) measures the active return of a portfolio divided by its tracking error (active risk), indicating the consistency of a manager's outperformance.
- Focuses on active management skill.
- Formula: (Portfolio Return - Benchmark Return) / Tracking Error.
- Higher IR indicates better performance per unit of active risk.
- Used to evaluate managers against a specific benchmark.
Memory trick: Info Ratio shows active skill, Sharpe for total thrill, Treynor for beta's will.