What Is Risk-adjusted Return? Why is SEBI Considering Making its Disclosure Mandatory for Mutual Funds?

What is risk-adjusted return?

Most investors choose mutual funds based on past returns, but while doing so they often ignore the underlying risks. You see, risk and returns are two sides of the same coin; higher returns are usually linked to higher risks. That is why, it is important to evaluate returns more meaningfully by assessing the risk involved. A 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.

Why is SEBI keen on making disclosure of risk-adjusted returns mandatory?

Since the volatility of performance is an important determinant in understanding the suitability of a scheme to an investor's risk profile, SEBI is considering that the risk-adjusted returns are mandatorily disclosed along with the scheme's performance.

Mutual funds houses are currently mandated to disclose periodic information regarding schemes' performance i.e. return on investment, with SEBI through various documents including scheme Annual Report, scheme's annual and half-yearly financial results, Scheme Information Document (SID), Key Information Memorandum (KIM), as well as on the websites of Association of Mutual Funds in India (AMFI) and respective asset management companies (AMCs).

In addition, AMCs also disclose scheme returns in schemes' abridged Annual Report, report to Trustee by AMCs, fund factsheets, product notes, etc.

However, the current regulatory framework does not mandate disclosure of risk-adjusted returns. Accordingly, not all AMCs disclose the risk-adjusted returns for all the categories of mutual fund schemes they manage. Further, there is no uniform practice followed by AMCs regarding the calculation as well as the frequency of disclosure of risk-adjusted returns of their schemes. SEBI has also observed that not all fund houses annualise the volatility (standard deviation) used to calculate the risk-adjusted returns of their schemes.

[Read: Are You Setting Your Risk-Return Expectations Right While Investing in Mutual Funds?]

What are SEBI's proposed norms regarding disclosure of risk-adjusted returns?

Risk-adjusted returns are determined using various financial ratios such as the Sharpe ratio, Sortino ratio, Treynor ratio, Jensen's Alpha, Information ratio, etc. SEBI is considering making disclosure of Information ratio mandatory to help investors evaluate how efficiently the portfolio returns are achieved relative to the level of risk taken.

Information Ratio helps measure the fund's returns above the returns of the benchmark index and even takes into account the volatility encountered for those returns.

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.

You can calculate the Information Ratio of the fund by using the formula Rp - Rm (also known as Tracking Difference) divided by the Tracking Error. In this, Rp is the Portfolio Return, Rm is the Market or Index Return, and TE is the Tracking Error.

The formula for calculation of Information ratio is as below:

Let's consider an example where 2 funds have generated similar returns of 14% over a year, as compared to a return of 12% by the market index, but have a Tracking Error of 1.08 for Fund A and 1.05 for Fund B.

If we want to pick one of these on the basis of their risk-adjusted returns and apply the formula -- Portfolio Return Minus the Benchmark Return and Divide it by the Tracking Error of the Fund, it will give us an Information Ratio of 1.85 for Fund A and 1.90 for Fund B. This indicates better risk-adjusted returns for Fund B.

A higher Information Ratio indicates that the fund manager is more consistent in generating returns relative to the benchmark. So, a fund with a higher Information Ratio could be preferred over a fund with a lower Information Ratio, provided that the performance of both schemes is being compared to the same benchmark under a particular category.

To ensure uniformity in the methodology used for calculation of the Information ratio for equity mutual fund schemes, SEBI has proposed using the Tier 1 benchmark in the formula. For debt-oriented schemes, the benchmark used in the formula may vary depending on the category of the scheme and the respective Tier 1 benchmark for each category. Meanwhile, for ETFs and Index Funds the present requirement for disclosure of Tracking Error and Tracking Difference will be considered sufficient to meet the volatility disclosure requirement.

SEBI's consultation paper for disclosure of risk-adjusted returns is open for public comments/suggestions till July 19, 2024.

To conclude:

While returns play a vital role in selecting mutual funds, it's important to consider more than just returns when evaluating mutual fund schemes. Understanding these risk ratios enables you to thoughtfully analyse mutual fund schemes that consistently perform well and could be a good fit for your investment goals.

SEBI's proposal for mandatory disclosure of risk-adjusted returns is a positive step that can empower investors to adopt a holistic approach to investment decisions. It can help investors pick the most suitable scheme across the various categories and sub-categories of equity mutual fund, and thereby earn optimal returns for the level of risk taken.

To understand in detail about the various risk ratios one can use to evaluate mutual fund performance click on the video below:

We are on Telegram! Join thousands of like-minded investors and our editors right now.

DIVYA GROVER is the co-editor for FundSelect, the flagship research service of PersonalFN. She is also the co-editor of DebtSelect. Divya is an avid reader which helps her in analysing industry trends and producing insightful articles for PersonalFN’s popular newsletter – Daily Wealth letter, read by over 1.5 lakh subscribers.
Divya joined PersonalFN in 2019 and has since then used stringent quantitative and qualitative parameters to analyse funds to provide honest and unbiased research to investors. She endeavours to enable investors to make an informed investment decision and thereby safeguard their wealth.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.