The Securities and Exchange Board of India (SEBI) wants mandatory disclosure of risk-adjusted returns from mutual funds and has asked the people to express their opinion on this matter, throwing open the forum of the general public and stakeholders in India. The immediate question, therefore is, what is risk-adjusted return?
As is the current practice, most investors select mutual funds for investment on the basis of past returns. However, one essential characteristic of most mutual funds – risk – is ignored. But gauging the risk in the fund is a very significant thing many gloss over.
Measure of risk
Risk-adjusted return is an important parameter that helps in determining how much excess returns were generated by the portfolio for each unit of risk taken.
It is against this backdrop that market regulator SEBI wants to introduce the concept of risk-adjusted returns in the country to find out whether the risk in a fund is in sync with the risk profile of the potential investor.
If SEBI has its way, asset management companies (AMCs) have to compulsorily reveal the risk-adjusted returns along with any report of the performance of a fund.
Risk-adjusted returns can be measured Information ratio, etc. One of the things that the market regulator is toying with is to make it mandatory for AMCs to publish this ratio. It will reveal how efficiently the portfolio returns were achieved considering the level of risk taken by the fund manager.
Information Ratio
Information Ratio can help you measure the fund manager’s ability to consistently generate benchmark-beating returns with a lower level of risk. The Tracking Error used in the calculation of the information ratio helps assess the consistency. The Tracking Error of the fund is the Standard Deviation (volatility) of the difference between the fund’s returns and the index returns.
One could find out the Information Ratio of the fund by using a particular formula. It runs thus: Rp – Rm (also known as Tracking Difference) divided by the Tracking Error.
There are two jargons here – tracking difference and tracking error.
Tracking difference is the discrepancy between the returns of a passive mutual fund (Index fund or ETF) and its guiding benchmark index.
On the other hand, tracking error is the difference between the scheme’s return and that of the benchmark. It is a measure of how closely a mutual fund replicates the returns of the identified benchmark.
The arithmetic
One can take example of two funds both of which have delivered 14% return over a year. The market index has given a 12% return. e market index, but have a Tracking Error of 1.08 for Fund A and 1.05 for Fund B since they follow different benchmark indices.
Therefore, the Information ratio for fund A will be calculated as (14-12)/1.08 = 2/1.08 = 1.85
The Information ratio for fund B will be (14-12)/1.05 = 2/1.05 = 1.90
Therefore, fund B has delivered higher risk-adjusted-returns.
Right now, rules don’t need mandatory announcement of risk-adjusted returns. If adopted it could lead to more enlightened decisions by experts and individuals towards investing.
Investors often choose mutual funds on the basis of past performance. SEBI is proposing the introduction of risk-adjusted returns that would be a new step in transparency and boost investor enlightenment. Personal Finance Business News – Personal Finance News, Share Market News, BSE/NSE News, Stock Exchange News Today
