Explanation

The information ratio is calculated as:

Information Ratio = Jensen's Alpha / Tracking Error

Where:

• Jensen's Alpha is the excess return of a portfolio over its expected return based on the Capital Asset Pricing Model (CAPM)
• Tracking Error is the standard deviation of the portfolio's excess returns relative to its benchmark

Tracking error represents the nonsystematic risk or idiosyncratic risk of the portfolio. This is the risk that is specific to the portfolio manager's investment decisions and not related to overall market movements.

Key Points:

1. Total variance includes both systematic (market) risk and nonsystematic (idiosyncratic) risk
2. Systematic variance is the portion of risk that cannot be diversified away (market risk)
3. Nonsystematic variance is the portion of risk that can be eliminated through diversification (idiosyncratic risk)

Since the information ratio measures a portfolio manager's ability to generate excess returns relative to a benchmark, it uses tracking error (nonsystematic risk) in the denominator to assess the consistency of the manager's outperformance.

Correct Answer: C - nonsystematic variance