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Why SEBI wants mutual fund investors to learn about information ratio?

Posted on 09 Jul 2024
Author: Sayan Sircar

Tags: News ; Mutual Funds

5 mins read
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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?

📚 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.

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.

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What are Tracking Error and Tracking Difference?

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.

Also read
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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

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