Chartered Financial Analyst (CFA) Practice Exam Level 2

Which component does NOT affect the Information Ratio?

1. Transfer Coefficient

2. Excess Return

3. Environmental risk

4. Breadth of decisions made

The correct answer is: Environmental risk

The Information Ratio is a measure of risk-adjusted return, specifically assessing the excess return generated by a portfolio relative to its benchmark, divided by the tracking error. It is primarily influenced by factors that contribute to the portfolio's ability to outperform the benchmark while managing the level of risk taken. The transfer coefficient reflects the effectiveness of a manager in translating a decision into a portfolio holding, and it plays a role in determining the portfolio's active return. Excess return is central to the Information Ratio, as it represents the difference in returns between the portfolio and the benchmark. The breadth of decisions refers to the number of independent investment decisions made, which can influence the potential for excess return and tracking error. In contrast, environmental risk, which encompasses factors such as regulatory and reputational risks, does not directly impact the Information Ratio. While environmental risk can affect overall portfolio performance and returns, it is not a component that is calculated within the Information Ratio itself. The Information Ratio focuses on active management metrics rather than broader external risks, making environmental risk an unrelated factor in this context.