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.
This article introduces the concept of the information ratio, which mutual funds may need to declare daily for their funds.
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.
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?
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.
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?
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.
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.
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?
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).
The information ratio should be just one of several metrics used to choose mutual funds. Some other additional metrics are:
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Published: 8 December 2024
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This post titled Why SEBI wants mutual fund investors to learn about information ratio? first appeared on 09 Jul 2024 at https://arthgyaan.com