Can the information ratio help you identify the right fund?

In the last year, the inflows in the mid-cap and small-cap funds have risen due to their phenomenal performance. Investors flock to these funds, hoping to earn stellar returns, ignoring the risk.

Why it matters?

SEBI, in its consultation paper, has proposed that all mutual funds disclose risk-adjusted returns instead of returns. This risk-adjusted return is called the information ratio.

SEBI wants an investor to consider the risk in generating returns rather than just focusing on the returns.

Zoom In

The information ratio is calculated as follows:

The higher the information ratio, the better it is, reflecting how well the fund has performed compared to the benchmarked index and the volatility.

In the above example, if it hadn’t been for the information ratio, you would have picked Fund A over Fund B as it gave a higher return.

What next?

It will offer a more comprehensive view of the fund.

The funds generally show standard deviation and Sharpe ratio in the scheme-related documents, which many investors fail to interpret.

Out of the 39 fund houses running equity schemes, 33 disclose the information ratio, while out of the 36 fund houses running hybrid schemes, just 27 disclose their risk-adjusted numbers.

Information ratio, although a helpful matrix, fails to tell how the outperformance was achieved. The rolling returns are a better option in this case.

In our in-house 2ROPE framework for selecting a mutual fund, we at A D Naik Wealth use the information ratio as one of the parameters to choose a fund.