{"id":19187,"date":"2021-08-05T15:10:37","date_gmt":"2021-08-05T15:10:37","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=19187"},"modified":"2026-05-30T21:00:43","modified_gmt":"2026-05-30T21:00:43","slug":"explain-how-the-information-ratio-may-be-useful-in-investment-manager-selection-and-choosing-the-level-of-active-portfolio-risk","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/explain-how-the-information-ratio-may-be-useful-in-investment-manager-selection-and-choosing-the-level-of-active-portfolio-risk\/","title":{"rendered":"Application of the Information Ratio"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"ImageObject\",\r\n  \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio.jpg\",\r\n  \"caption\": \"Optimal-Portfolio\",\r\n  \"width\": 1590,\r\n  \"height\": 1296,\r\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\r\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\r\n  \"creditText\": \"AnalystPrep Design Team\",\r\n  \"creator\": {\r\n    \"@type\": \"Organization\",\r\n    \"name\": \"AnalystPrep\"\r\n  }\r\n}\r\n<\/script>\r\n<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"What is the optimal level of active risk given a benchmark Sharpe ratio and information ratio?\",\r\n    \"text\": \"A portfolio manager uses a benchmark portfolio with a Sharpe ratio of 0.30 and a total risk of 12.0%. His actively managed portfolio has an information ratio of 0.25 and an active risk of 5.0%. The portfolio\u2019s optimal level of active risk is closest to: A. 10%. B. 12%. C. 15%.\",\r\n    \"answerCount\": 3,\r\n    \"suggestedAnswer\": [\r\n      { \"@type\": \"Answer\", \"text\": \"A. 10%\" },\r\n      { \"@type\": \"Answer\", \"text\": \"B. 12%\" },\r\n      { \"@type\": \"Answer\", \"text\": \"C. 15%\" }\r\n    ],\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"The correct answer is A. The optimal active risk is calculated as (Information Ratio \u00f7 Benchmark Sharpe Ratio) \u00d7 Benchmark Total Risk. Substituting the values gives (0.25 \u00f7 0.30) \u00d7 12.0% = 10.0%. Therefore, the portfolio\u2019s optimal level of active risk is approximately 10%.\"\r\n    },\r\n    \"author\": {\r\n      \"@type\": \"Organization\",\r\n      \"name\": \"AnalystPrep\"\r\n    }\r\n  }\r\n}\r\n<\/script>\r\n\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/jg7OkPKXBSs\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<p>An optimal portfolio can be obtained by combining a risk-free asset with an optimally risky asset portfolio. The <strong>optimally risky asset portfolio<\/strong> is the point where the capital allocation line is tangent to the efficient frontier.<\/p>\r\n<p><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter size-full wp-image-26647\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio.jpg\" alt=\"Optimal Portfolio\" width=\"1590\" height=\"1296\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio.jpg 1590w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio-300x245.jpg 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio-1024x835.jpg 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio-768x626.jpg 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio-1536x1252.jpg 1536w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/08\/Optimal-Portfolio-400x326.jpg 400w\" sizes=\"auto, (max-width: 1590px) 100vw, 1590px\" \/>The optimal portfolio is the one with the <strong>highest possible Sharpe ratio<\/strong>. Therefore, irrespective of an investor&#8217;s risk aversion, they need to find a single risky asset portfolio with the highest Sharpe ratio, such that the following equation holds.<\/p>\r\n<p>$$ SR_P^2=SR_B^2+IR^2 $$<\/p>\r\n<p>Additionally, the portfolio with the highest information ratio has the highest Sharpe ratio. However, this may not be the ideal case when IR is negative. Consequently, the mean-variance theory asserts that the best criterion for active performance assessment is using the expected information ratio, especially when using the same benchmark.<\/p>\r\n<p>The information ratio is also applied in the determination of the optimal level of active risk for unconstrained portfolios:<\/p>\r\n<p>$$ STD\\left(R_A\\right)=\\frac{IR}{SR_B}{STD}(R_B) $$<\/p>\r\n\r\n<div style=\"margin: 18px 0;\"><a style=\"display: block; text-align: center; padding: 14px 18px; border: 2px solid #2F5BFF; border-radius: 18px; color: #ffffff ; font-weight: 600; font-size: 16px; text-decoration: none; background-color: #1a73e8 ;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">Practice CFA Level II information ratio concepts with our Free Trial.  <\/a><\/div>\r\n\r\n<h4>Example: Optimal Level of Active Risk<\/h4>\r\n<p>Calculate the optimal level of aggressiveness in an actively managed portfolio with an information ratio of 0.20. Further, assume that the benchmark portfolio has a Sharpe ratio of 0.25 and a total risk of 15.0%<\/p>\r\n<h4>Solution<\/h4>\r\n<p>Using the equation:<\/p>\r\n<p>$$ \\begin{align*} STD\\left(R_A\\right) &amp; =\\frac{IR}{SR_B}STD(R_B) \\\\ STD\\left(R_A\\right) &amp; =\\left(\\frac{0.20}{0.25}\\right)\\times15\\%=12.0\\%. \\\\ \\end{align*} $$<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>A portfolio manager uses a benchmark portfolio that has a Sharpe ratio of 0.30 and a total risk of 12.0%. His actively managed portfolio has an information ratio of 0.25 and an active risk of 5.0%. The portfolio&#8217;s optimal level of active risk is <em>closest to<\/em>:<\/p>\r\n<ol type=\"A\">\r\n\t<li>10%.<\/li>\r\n\t<li>12%.<\/li>\r\n\t<li>15%.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is A.<\/strong><\/p>\r\n<p>$$ \\begin{align*} STD\\left(R_A\\right) &amp; =\\frac{IR}{SR_B}STD(R_B) \\\\ STD\\left(R_A\\right) &amp;=\\left(\\frac{0.25}{0.30}\\right)12.0\\%=10.0\\%. \\end{align*} $$<\/p>\r\n<\/blockquote>\r\n<p>Reading 44: Analysis of Active Portfolio Management<\/p>\r\n<p><em>LOS 44 (d) Explain how the information ratio may be useful in investment manager selection and choosing the level of active portfolio risk.<\/em><\/p>\r\n\r\n<div style=\"text-align: center; margin: 30px 0;\"><a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 12px 26px; border-radius: 9999px; background: #1e5bd8; color: #ffffff; font-weight: bold; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"> Start Free Trial \u2192 <\/a> <p style=\"margin-top: 12px; font-size: 16px; line-height: 1.5;\">Access CFA Level II portfolio management study notes, practice questions, item sets, and video lessons to strengthen your understanding of the information ratio, manager selection, and active portfolio risk. <\/p>\r\n <\/div>\r\n","protected":false},"excerpt":{"rendered":"<p>An optimal portfolio can be obtained by combining a risk-free asset with an optimally risky asset portfolio. The optimally risky asset portfolio is the point where the capital allocation line is tangent to the efficient frontier. The optimal portfolio is&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,473],"tags":[216,564],"class_list":["post-19187","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-portfolio-management","tag-cfa-level-2","tag-portfolio-management","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.6 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Information Ratio Applications | AnalystPrep<\/title>\n<meta name=\"description\" content=\"Learn how the information ratio is used to evaluate managers and determine the optimal level of active portfolio risk.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link 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