The Right Question to Ask About Active Funds

An active fund manager claims to beat the market. How do you evaluate that claim?

The naive approach: look at raw returns. "This fund returned 18% last year; the index returned 14%; the manager added 4%." But this ignores risk. Did the manager achieve those 4 percentage points of excess return by taking double the risk of the index? By concentrating in three stocks that happened to rally? Or by consistently generating excess return across many independent bets, regardless of market conditions?

The correct question is not "how much did the manager beat the benchmark?" but "how much alpha did the manager generate per unit of active risk taken?"

This ratio has a name: the Information Ratio.

$$IR = \frac{E[\alpha]}{TE}$$

where $E[\alpha]$ is the expected alpha (active return — return above the benchmark) and $TE$ is the tracking error (Volatility) — definition">standard deviation of the active return). The IR tells you how efficiently the manager converts active risk into active return.

An IR of 0.5 means: for every 1% of tracking error the manager runs, they deliver 0.5% of alpha. An IR of 1.0 means they deliver 1% of alpha per 1% of tracking error. An IR of 0.0 means they are taking active risk but generating no active return — exactly what you would expect from random stock selection after fees.

Why the IR is the right metric:

Two funds both beat the Nifty 50 by 3% per year over 5 years.

• Fund A has tracking error of 12% → IR = 3/12 = 0.25
• Fund B has tracking error of 4% → IR = 3/4 = 0.75

Fund B is generating the same alpha at one-third the active risk. Fund B's manager is demonstrably more skilled: they are efficiently converting information advantage into return, without unnecessary active risk.

Fund A might have simply gotten lucky with concentrated bets. Fund B is consistently generating modest outperformance across many positions — the signature of genuine, scalable skill.