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ℹ️ SEBI Gives More 'Information' to Mutual Fund Investors
But do you really need it?
Madhu, Altcase
July 17, 2024
Welcome to this week’s Altsights!
The SEBI recently mandated mutual funds to publish the ‘Information Ratio’ of all their schemes.
This move is aimed at providing more risk-related information to investors and helping them make better investment decisions.
Today, we’ll look at the 'Information Ratio’ in depth and discuss 3 more risk-related metrics that can help you select mutual funds better.
Think of a student (investment) and the class average (benchmark). Suppose the student's extra study hours (risk) lead to higher grades (returns).
In this context, the information ratio would show how higher the student's grades are compared to the class average, for each extra hour of studying.
A higher information ratio indicates a better risk-adjusted performance. This means that the fund is making better investment decisions while taking on extra risk rather than taking on extra risk just for the sake of it.
Let’s consider the example shared by the SEBI:
Assume there are two small-cap funds, T and S. The table below shows the information ratio (IR) for these funds over the past year:
Fund T | Fund S | |
|---|---|---|
Excess Return (A) | 7.20% | 4.70% |
Annualised SD (B) | 7.42% | 7.52% |
Information Ratio (A/B) | 0.97 | 0.63 |
Fund T earned an excess return of 7.2%, higher than Fund S’s 4.7% over one year. However, both T and S have similar annualised volatility (same as standard deviation or risk).
Because of this, Fund T has a higher Information Ratio (0.97) compared to Fund S (0.63).
This means Fund T has generated more excess return with almost the same level of risk and consistency as Fund S.
Overall, this move by SEBI could enhance transparency and drive a higher standard of fund management within the industry
More Mutual Fund Risk Metrics 🚨
Beta (β) is a measure that compares the volatility or risk of a fund or stock to the overall market. It indicates how much the price of a security has changed relative to the changes in the market.
Beta value | What it means? |
|---|---|
Equal to 1 | As volatile as the market |
Greater than 1 | More volatile than the market |
Lower than 1 | Less volatile than the market |
Lower than 0 | Moves in the opposite direction of the market |
Tips to Use Beta Properly:
A higher beta indicates higher risk, but not necessarily higher returns
If the stock markets are too volatile for you, prefer low-beta equity funds
Beta comparisons are most meaningful when the funds belong to the same category, such as mid-cap funds
Beta is pure risk measure and should be combined with a return measure (like alpha) for a complete view of a fund’s performance
Standard deviation indicates how much the returns on your funds have deviated from the expected normal returns. A higher standard deviation indicates higher volatility and risk.
If a fund has an average return of 15% and a standard deviation of 5%, it means the returns typically fluctuate by 5% from the average. So, the returns have mostly been in the 10% to 20% range.
A lower standard deviation indicates that the fund has delivered fairly predictable returns with minimal volatility.
Tips to Use Standard Deviation Properly:
For equity funds, long-term standard deviation (3+ years) should be looked at since short-term standard deviation would be very high across most funds yielding little to no information
Standard deviation is most meaningful when comparing investments within the same asset class, eg., equity funds
Standard deviation is a pure risk measure and should be combined with a return measure for the complete view of a fund’s performance
Sharpe ratio is the most popular metric used to measure risk-adjusted returns.
It indicates how much excess return you receive for the additional volatility you endure for holding a riskier asset.
Higher Sharpe ratio is desirable as it indicates higher return per unit of risk taken.
Sharpe ratio value | What it means? |
|---|---|
Equal to 1 | If the fund took 1% more risk, it generated 1% extra return |
Lower than 1 (bad!) | If the fund took 1% more risk, it generated less than 1% extra return |
Greater than 1 (good!) | If the fund took 1% more risk, it generated more than 1% extra return |
Tips to Use Sharpe Ratio Properly:
Sharpe ratio measures risk-adjusted return and can be used to compare overall performance of mutual funds in the same category
Sharpe ratio penalises volatility on the upside too. Sortino ratio, a risk-adjust return measure similar to Sharpe ratio, doesn’t
Sharpe ratio comparisons are more accurate when the funds belong to the same category such as small-cap funds
You might find that the ‘Information Ratio’ and ‘Sharpe Ratio’ are similar. So, here’s a quick table to show the distinctions between the two:
Aspect | Sharpe Ratio | Information Ratio |
|---|---|---|
Numerator (return) | Excess return over the risk-free rate | Excess return over the benchmark |
Denominator (risk) | Overall risk of the mutual fund scheme | Excess risk over the benchmark |
Indicates | Risk-adjusted return of the mutual fund scheme with risk-free rate as the benchmark | Scheme’s ability to generate excess return per unit excess risk (compared to the benchmark) |
Shortcoming | Considers upside volatility as bad as downside volatility | Easy to manipulate by choosing a convenient benchmark index |
Do You Really Need These Risk Metrics Though? 🤔
While these risk metrics could be quite helpful in mutual fund selection, I believe most investors skip a step or two and dive straight into them.
Here are 3 more important metrics or factors that you should consider while selecting mutual funds:
Investment Horizon and Financial Goals
First, nail down your investment horizon and financial goals. It will help you identify what category of mutual funds are suitable. The mutual fund selection comes much later!Fund Manager Reputation and Experience
When you select mutual fund schemes, value the fund manager more than its recent performance. If you stick around in an experienced fund manager’s scheme across a full market cycle, it is unlikely you’ll go wrong.Rolling Returns
I mention this because most investors choose mutual funds based on just the last 1 year or 3 year returns. I recently wrote a LinkedIn post explaining why this is a fallacy and the advantages of rolling returns.
Reader’s Spotlight💡
Last week, Swaroop from Mysore asked:
Does the launch of so many NFOs indicate that the market has peaked?
The market does feel overvalued, especially the mid and small cap segments.
However, I don't like to get into the almost impossible business of predicting market tops and bottoms. I believe a disciplined approach like mutual fund SIPs is the best way to invest in the markets over the long-term.
So, continue your SIPs if you have them running. It's also okay to start new SIPs for the long-term if you have been contemplating.
But for periods up to 3 years, instruments like fixed deposits, debt funds and bonds should be preferred.
Like Swaroop, are you too curious about personal finance and investing?
I’d love to hear from you!
Simply reply to this email with your question. Each week, I'll select the most insightful question and answer it for everyone’s benefit.
So, go ahead and ask. I can't wait to engage in meaningful conversations!
Cheers,
Madhu,
Founder, Altcase