How does the Sharpe ratio differ from the information ratio?

The Sharpe ratio and the information ratio are both tools used to evaluate the risk-adjusted rate of return of an investment portfolio. They differ in the baseline against which each measures, or compares, the investment return.

The Sharpe ratio is perhaps the most widely used tool for evaluating risk-adjusted rate of return on investment portfolios. It does so by comparing the actual or expected return on an investment to the return on a risk-free investment, such as U.S. Treasury bills. It compares the two rates of return, factoring in the standard deviation for the investment portfolio, to provide an investor with an idea of how much additional gain he or she is receiving (if any) in return for taking on the additional risk associated with investing in equities.

The information ratio also seeks to evaluate risk-adjusted return in relation to a baseline investment. Rather than using a risk-free investment for comparison purposes, the information ratio commonly measures the rate of return of an investment portfolio against a benchmark equity index. The most frequently used benchmark is the S&P 500 index. The information ratio compares the rates of return on active portfolio management, in which an investor or portfolio manager makes the specific investment decisions regarding which stocks to buy, with the rate of return that would be realized through passive portfolio management, the result that would be achieved if an investor were to invest all his or her funds in an index fund. The information ratio can also provide an indication of the consistency of an investment portfolio's performance; it indicates whether the actively managed portfolio consistently outperforms passive portfolio management by a small amount month to month or if it outperforms a passive investment portfolio by a large amount during a few months of the year.