The Appraisal Ratio measures alpha generated by a fund manager relative to the idiosyncratic (unsystematic) risk they took — the Information Ratio but specifically for residual/unsystematic risk.
Appraisal Ratio = Alpha ÷ Residual Risk (Tracking Error). Alpha is the return above what CAPM predicts given the fund's beta. Residual Risk (also called Unsystematic Risk or Idiosyncratic Risk) is the component of tracking error that cannot be explained by market risk — it's the risk the manager takes through individual stock selection bets. The Appraisal Ratio rewards managers who generate alpha from stock-picking skill while penalising those who generate alpha through excessive unsystematic risk-taking.
The Appraisal Ratio is the Information Ratio's more precise sibling: it asks 'how efficiently does this manager convert individual stock-picking risk into alpha?' A manager with an Appraisal Ratio of 0.8 extracts 0.8 units of alpha per unit of individual-stock risk taken. Higher is better — it means the stock picks are working hard relative to the risk they add to the portfolio.
Calculate Jensen's Alpha: actual return − (Rf + β × (Rm − Rf)).
Calculate residual/idiosyncratic risk: standard deviation of (return − predicted CAPM return).
Appraisal Ratio = Alpha ÷ Residual Standard Deviation.
Higher Appraisal Ratio = more alpha per unit of unsystematic risk taken.