CFA Level II ExamPortfolio Management and Wealth PlanningMedium
A portfolio manager for a large endowment fund is tasked with evaluating the fund's historical performance. The fund has consistently outperformed its benchmark, generating an annualized excess return of 2% with a tracking error of 1.5%. The manager wants to understand the consistency of this outperformance. What is the most appropriate performance measure to assess the consistency of the fund's active returns relative to its active risk?
- ASharpe Ratio
- BInformation Ratio
- CSortino Ratio
- DTreynor Ratio
Show answer & explanationAnswer & explanation
Correct answer: B. Information Ratio
The Information Ratio (IR) is specifically designed to measure the consistency of a manager's active returns (excess return over benchmark) relative to the active risk taken (tracking error). A higher IR indicates more consistent outperformance for the level of active risk assumed. The question explicitly asks for a measure of consistency of outperformance relative to active risk.
Why the other options are wrong
- A. The Sharpe Ratio measures total risk-adjusted return, not active risk-adjusted return or consistency of outperformance against a benchmark.
- C. The Sortino Ratio measures downside deviation-adjusted return, focusing on undesirable volatility, not active risk against a benchmark.
- D. The Treynor Ratio measures systematic risk-adjusted return, using beta as the risk measure, not active risk (tracking error).
Information Ratio (IR)
A measure of a portfolio manager's skill and the consistency of their active returns. It quantifies the amount of active return generated per unit of active risk.
- Calculated as (Portfolio Return - Benchmark Return) / Tracking Error.
- Higher IR indicates better and more consistent active management.
- Used for evaluating active managers and comparing their effectiveness.
Memory trick: Active Eval: IR is Your Insight Report.