Sebi’s information ratio proposal: Clear insight or investor overload?

On 28 June, the Securities and Exchange Board of India (SEBI) proposed a new measure to improve transparency in mutual fund performance: the mandatory disclosure of risk-adjusted returns using the information ratio. While this aims to provide investors with a clearer picture of fund performance, some experts are concerned it might lead to information overload for retail investors.

The key question, therefore, is whether this new metric will genuinely help investors make better and informed decisions or just complicate the landscape further.

The information ratio measures a fund's outperformance against a benchmark, divided by the volatility of this outperformance. This metric aims to convey not just outperformance but also its consistency.

The Sebi's move aims to address a discrepancy in traditional or existing measures, wherein past one- or three-year returns often fail to capture the associated risks, leading investors to sometimes choose funds based solely on recent performances.

For instance, consider two funds: Fund A and Fund B. Fund A has delivered consistent, moderate returns over five years, while Fund B has shown spectacular returns in the last year. Investors might gravitate towards Fund B due to its impressive recent performance, unaware that its higher returns come with higher risk, implying significantly higher volatility and potential for substantial losses during market downturns.

Therefore, it's essential to evaluate the risks taken to generate returns, ensuring the fund's risk level aligns with an investor's risk appetite and financial goals, and safeguarding financial stability.

Most fund houses use the sharpe ratio to measure risk-adjusted returns, showing how much excess return you make for the extra volatility endured. It is calculated by taking portfolio returns minus the risk-free rate and dividing it by the standard deviation of portfolio returns.

However, Sebi's consultation paper proposes using the information ratio instead as the measure for risk adjusted returns. Unlike the sharpe ratio, which compares an investment's return to the risk-free rate, the information ratio compares it to a benchmark, providing a more specific measure of a manager's performance relative to an index.

According to industry experts, the information ratio offers a clearer picture of a fund manager's skill. “It's a welcome step and information ratio is important as it helps compare the consistency of returns of a mutual fumd (MF) scheme with other schemes or benchmarks on a risk adjusted basis. The higher the ratio the better is the consistency of return” said Abhishek Kumar, a Sebi-registered investment advisor (RIA)

“It helps in settling the debate about active versus passive fund management, as using this ratio one can identify how much of alpha return over benchmark return is consistently generated by a fund manager for a given level of risk by bringing in tracking error into the picture instead of just calculating the alpha return using tracking difference,” he added.

Nirav karkera, head of research at Fisdom, said standardising the calculation on the information ratio will bring uniformity, ensuring all mutual funds use the same method to measure and report their risk-adjusted returns. “A key objective that this ratio could achieve is bringing in uniformity in the way risk-adjustment metrics are computed. This will enable effective comparison across schemes and empower more informed decision making.”

But, how will this impact you?

The introduction of the information ratio is expected to impact investors in varied ways across different segments.

For retail investors, there are concerns about information overload. Vidya Bala co-founder of PrimeInvestor, said the addition of the information ratio to existing metrics, such as the Sharpe ratio, might confuse retail investors. “Providing an information ratio on top of Sharpe can simply become information overload for a retail investor.”

Besides, retail investors might find it challenging to interpret and use the information ratio effectively without adequate financial literacy. To address this, an initial period of adjustment and learning may be required for this segment. “We prefer a simple percentage of times that a fund beats its benchmark using rolling returns,” she added.

According to a section of experts, informed and seasoned investors are however likely to benefit significantly from the introduction of the information ratio.

Abhishek Kumar, a Sebi-registered investment advisor, underscored the ability to compare the consistency of a mutual fund's returns with other schemes or benchmarks on a risk-adjusted basis. "The higher the ratio, the better the consistency of return." This ratio provides a more nuanced view of a fund's performance, aiding in making more informed decisions and fine-tuning their investment strategies, he added.

For fund houses, the adoption of the information ratio may lead to a shift in portfolio management approaches. Niranjan Avasthi, head of product and marketing at Edelweiss Asset Management Ltd, said the information ratio is a valuable metric for assessing risk-adjusted returns. "It measures the fund's excess return over a benchmark relative to the volatility of those returns."

“Fund managers might be incentivized to optimise their strategies to improve their information ratio, potentially leading to more prudent risk management and better performance for investors. Overall, this move by Sebi could enhance transparency and drive a higher standard of fund management within the industry,” Avasthi added.

While the impact of the information ratio may vary across different investor segments, its introduction is expected to enhance the overall transparency and facilitate better decision-making.