Why SEBI wants mutual fund investors to learn about information ratio?
This article introduces the concept of the information ratio, which mutual funds may need to declare daily for their funds.
Why SEBI wants mutual fund investors to learn about information ratio?
Posted on 09 Jul 2024
Author: Sayan Sircar
5 mins read
📢Join 3400+ readers on WhatsApp and get new post notifications!
This article introduces the concept of the information ratio, which mutual funds may need to declare daily for their funds.
📚 Topics covered:
- What is the news?
- What is Risk Adjusted Return (RAR)?
- What are Tracking Error and Tracking Difference?
- Why does SEBI want mutual funds to declare Risk-Adjusted Return (RAR)?
- Do mutual funds already disclose information ratio?
- How should you interpret the concept of Risk-Adjusted Return (RAR)?
- What happens next on Risk-Adjusted Return (RAR) disclosure?
- Is the concept of Risk-Adjusted Return (RAR) enough to choose between mutual funds?
What is the news?
On 28-Jun-2024, SEBI came up with a consultation paper:
The objective of this consultation paper is to seek comments/views from the public on the proposal regarding the disclosure of Risk-Adjusted Return of the portfolio of a Mutual Fund scheme (MF Scheme), thereby enabling informed investment decisions by the investors.
The paper provides a framework, calculation method, and disclosure rules for the Information Ratio (IR) as the Risk-Adjusted Return (RAR) for mutual funds as a daily metric.
What is Risk Adjusted Return (RAR)?
Risk Adjusted Return (RAR) is another term for Information Ratio (IR). As explained in our post on common statistical terms used in Investing,
Information Ratio = (Rp - Rb) / σ(Rp - Rb)
🛈 What is Information Ratio?
The Information Ratio measures the returns of an investment above the returns of a benchmark, relative to the volatility of those returns. It helps to assess the consistency of an investment’s performance.
If a mutual fund has a return of 14%, the benchmark return is 10%, and the tracking error (standard deviation of the difference) is 2%, the Information Ratio is (14% - 10%) / 2% = 2.
If a mutual fund has a return of 14%, the benchmark return is 10%, and the tracking error (standard deviation of the difference) is 2%, the Information Ratio is (14% - 10%) / 2% = 2.
In simpler terms,
Information Ratio = Tracking difference / Tracking error
The higher the information ratio, the better the consistency in getting excess returns over the fund’s benchmark.
What are Tracking Error and Tracking Difference?
Image ©: Vanguard - https://www.ch.vanguard/en/professional/events-education/etfs/management
Tracking difference = Fund return - Benchmark return
Investors can think of this number as essentially how much higher return a mutual fund gives over the benchmark.
Tracking error = standard deviation of Tracking difference
By definition, this is always a positive number and shows how much the Tracking difference varies around its average value. Most AMCs declare tracking errors in their ETFs and index funds. The ideal tracking error is zero, and the next best value is a very small number.
These terms like average and standard deviation are explained here: Which are the common statistical terms used in Investing?
Why does SEBI want mutual funds to declare Risk-Adjusted Return (RAR)?
SEBI wants to standardize how mutual funds can be compared amongst themselves. Too often, investors choose funds based only on return without truly understanding the volatility of that fund. The concept of Risk-Adjusted Return (RAR), being disclosed using a consistent and comparable calculation method, will be helpful to investors.
Do mutual funds already disclose information ratio?
Some AMCs already declare Risk-Adjusted Return (RAR). The rest mostly do not. The SEBI proposal, once made into a circular, will bring in consistency and provide a common calculation methodology.
How should you interpret the concept of Risk-Adjusted Return (RAR)?
Here is a matrix that can help you choose between two funds to locate the more consistent performer like this:
| Tracking Difference | Tracking Error | Information Ratio | Decision |
|---|---|---|---|
| > 0 for both | Always positive | > 0 | Higher IR is better |
| < 0 for one | Always positive | Opposite signs | Higher IR is better |
| < 0 for both | Always positive | Both negative sign | Higher IR is better |
| Same for both funds | Different | Different | Higher IR is better |
| Different | Same for both funds | Different | Higher IR is better |
If two funds have the same Information Ratio, then either choose the one with the higher absolute return or the lower absolute risk.
You can use this metric to compare funds across within the same category only. Do not, for example, compare a hybrid fund (with both equity and debt allocation) vs. a large cap equity fund since their risk exposures are different.
Interestingly, by construction, index funds always have negative Tracking Differences. Between multiple index funds, the best one is the one with the highest information ratio: Which are the best and worst index funds of India?
What happens next on Risk-Adjusted Return (RAR) disclosure?
The public is invited to provide their opinions on this consultation paper here. Once opinions have been received and assessed, SEBI is expected to come up with an actual circular on the topic of disclosure of Risk-Adjusted Return (RAR).
Is the concept of Risk-Adjusted Return (RAR) enough to choose between mutual funds?
The information ratio should be just one of several metrics used to choose mutual funds. Some other additional metrics are:
- Rolling returns and risk: What are the rolling returns of SIP and lump sum of direct mutual funds?
- Fund manager style
- Expense ratio
- Fund size
What's next? You can join the Arthgyaan WhatsApp community
You can stay updated on our latest content and learn about our webinars. Our community is fully private so that no one, other than the admin, can see your name or number. Also, we will not spam you.For resident Indians 🇮🇳:
For NRIs 🇺🇸🇬🇧🇪🇺🇦🇺🇦🇪🇸🇬:
Share on WhatsApp: To understand how this article can help you:
If you have a comment or question about this article
The following button will open a form with the link of this page populated for context:If you liked this article, please leave us a rating
The following button will take you to Trustpilot:Discover an article from the archives
Previous and next articles:
Latest articles:
Market Movements
Portfolio Review
How much money will you lose if the stock market falls in the short term?
This article shows you the amount of loss you will potentially make when the stock market falls in the short term and how to deal with such a market fall.
Published: 20 October 2024
5 MIN READ
Topics you will like:
Next steps:
1. Email me with any questions.
2. Use our goal-based investing template to prepare a financial plan for yourself.Don't forget to share this article on WhatsApp or Twitter or post this to Facebook.
Discuss this post with us via Facebook or get regular bite-sized updates on Twitter.
More posts...Disclaimer: Content on this site is for educational purpose only and is not financial advice. Nothing on this site should be construed as an offer or recommendation to buy/sell any financial product or service. Please consult a registered investment advisor before making any investments.
This post titled Why SEBI wants mutual fund investors to learn about information ratio? first appeared on 09 Jul 2024 at https://arthgyaan.com
We are currently at 483 posts and growing fast. Search this site: Copyright © 2021-2024 Arthgyaan.com. All rights reserved.