Sharpe and Information Ratios: Risk and Benchmark Choices

Summary

The document compares two performance measures used to assess investment returns. The Sharpe ratio subtracts the risk-free rate from portfolio return and scales the result by the standard deviation of portfolio returns. The information ratio instead measures return above a benchmark and scales it by tracking error, the standard deviation of active returns. These definitions explain why the ratios can look structurally similar while measuring different things: their reference returns and risk denominators differ.

The excerpt raises concerns about using the Sharpe ratio for hedge funds, whose returns may be skewed, and about selecting a suitable benchmark for the information ratio. It does not resolve those concerns or provide evidence comparing the measures. In particular, the quoted claim that standard deviation makes Sharpe inappropriate for non-normal returns is presented without qualification; the formulas alone do not establish that conclusion. The practical lesson is to understand each measure’s assumptions and benchmark choice before interpreting a performance figure.

Key ideas

• The Sharpe ratio scales excess return over the risk-free rate by total return volatility.
• The information ratio scales active return over a benchmark by tracking error.
• The measures use different reference returns and different definitions of risk.
• Skewed returns and benchmark selection are raised as potential concerns for hedge fund evaluation.

Tags

# Difference between Sharpe Ratio and Information Ratio when measuring Hedge Fund performance?


# Difference between Sharpe Ratio and Information Ratio when measuring Hedge Fund performance?












Here is an unpublished excerpt from Professor X:

"Since Sharpe ratio uses standard deviation as a measure of risk, it assumes normal distribution of the underlying returns and it would therefore not be appropriate to use as a performance measure for hedge funds.

Information ratio avoids some, but not all, of the issues with skewness, as it uses mean return. Even if the skewness problem is avoided, choosing the appropriate benchmark for a hedge fund to be able to apply the information ratio calculation is not easy. There is very few of hedge fund style-specific benchmarks available, although some general hedge fund indices do exist."

Now I fail to see how this point adds up given that the two measures look identical apart from using the Risk free rate instead of Benchmark return in the former

## Answer by Logic9 (score 1)

https://quant.stackexchange.com/a/34248

Sharpe is (Portfolio Return - RFR) / Standard Deviation.

Information Ratio is (Portfolio Return - Benchmark Return) / Tracking Error,

where tracking error is the standard deviation of the active return.

I don't understand Professor X's comment either.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.