Mutual funds are often praised as a reliable option for diversifying portfolios and achieving long-term financial growth. But, like any investment, they carry risks. A key metric to evaluate whether a mutual fund justifies its risk is the Information Ratio (IR). Zerodha, a prominent stockbroking platform in India, has recently emphasized the significance of this frequently overlooked measure.

SEBI, India’s market regulator, has made it mandatory for mutual funds to share the Information Ratio (IR) as a new way to evaluate the risk-adjusted returns of equity-focused schemes. This rule will only apply to mutual fund schemes that invest mainly in equities. The Information Ratio is specifically intended for equity mutual fund schemes. According to SEBI rules, mutual funds must display the Information Ratio of a scheme, along with other performance details, on their website every day. Let’s get into the depth of this blog to learn what Zerodha explained about the information ratio.

What is the Information Ratio?

The Information Ratio (IR) is a key tool for evaluating a mutual fund’s performance. It measures how well a fund has performed relative to its benchmark, taking into account the level of risk managed by the fund’s manager. IR is basically a performance metric used to assess the risk-adjusted return of an investment portfolio or mutual fund. Information Ratio measures the excess return a fund manager achieves for each unit of risk taken, in comparison to a benchmark index.

What is the formula used to calculate the IR?

Information ratio formula:

IR = (Fund Return – Benchmark Return) / Tracking Error

Where:

  • Fund Return: The return generated by the mutual fund.
  • Benchmark Return: The return of the benchmark index to which the fund is compared.
  • Tracking Error: The standard deviation of the difference between the fund’s returns and the benchmark’s returns.

A higher Information Ratio suggests that the fund manager has been successful in consistently outperforming the benchmark with minimal additional risk.

Features of Information ratio (IR) explained by Zerodha

1. Evaluating Funds with IR

Zerodha highlights that IR is useful for assessing a fund’s performance relative to its benchmark while considering the risks involved. It demonstrates how effectively a fund manager performs over time while managing risk.

Explanation – When evaluating mutual fund schemes, understanding the volatility of performance is key. IR is a widely used financial metric to measure a scheme’s risk-adjusted return. It not only assesses how well a portfolio manager generates returns above the benchmark but also indicates performance consistency by accounting for risk and standard deviation.

2. Assessing Risk – Returns

IR tells you how much extra return a fund generates for each unit of risk it takes, compared to its benchmark. It emphasizes the fund manager’s consistency and skill, rather than just strong performance in a bull market. For example, if Manager A delivers a 30% return with low risk, and Manager B achieves a 40% return with higher risk, the Information Ratio (IR) helps determine which manager is better at producing returns while managing risk.

Explanation – SEBI’s initiative aims to increase transparency in disclosures from AMCs, allowing investors to make more informed decisions

3. Balancing Risk and Returns

The information Ratio is important because funds taking on excessive risk might perform well in good times but struggle during tough periods. IR helps you assess whether the returns are worth the risk involved. Other metrics like Beta and the Sharpe ratio focus on different aspects of performance. However, IR combines both risk and return to provide a clearer picture of a fund’s overall performance.

Explanation – SEBI emphasized the importance of the Information Ratio as a vital measure of a fund’s performance relative to its risk. By factoring in standard deviation, which gauges volatility, IR effectively captures both returns and performance consistency.

4. Better Investment Choices

It is highly useful because high returns don’t always mean a good investment if the fund is taking on too much risk. By looking at the Information Ratio (IR), investors can make better choices by considering both return and risk.

Explanation – SEBI has mandated mutual funds to display the Information Ratio of a portfolio scheme on their websites daily, along with other performance details. Amfi is responsible for ensuring that this information is accessible in a consistent, downloadable, and machine-readable format on their website.

Why the Information Ratio (IR) is Important?

  1. Consistency in Performance: A high Information Ratio indicates that the fund manager consistently outperforms the benchmark, which is key for building long-term wealth.
  2. Risk Management: It shows how well the fund manager manages risks while aiming to outperform the benchmark.
  3. Decision-Making Tool: Investors can use the Information Ratio to compare different mutual funds, helping them select the one that delivers superior risk-adjusted returns.
  4. Evaluation of Manager Skill: The Information Ratio helps assess a manager’s ability to generate returns consistently, not just during favorable market conditions, giving investors confidence in the manager’s skill.
  5. Understanding Volatility: By factoring in tracking error, the Information Ratio helps investors understand the level of volatility in a fund’s performance, offering a clearer picture of the potential risks involved.

What risk does the Investor have to face if ignoring the Information Ratio?

  • Investors who overlook the Information Ratio may choose funds that appear attractive based on past performance but lack consistency or involve too much risk. For instance:
  • A fund with a low IR may have shown high returns in the past due to risky investments, but such returns might not be reliable going forward.
  • Neglecting this metric could lead to an imbalanced portfolio, increasing exposure to unnecessary volatility.

Zerodha’s Insights: Key Points to Consider

Zerodha highlights that although mutual funds are a great investment option, it’s important to understand risk-adjusted metrics like the Information Ratio to make well-informed choices. The platform recommends:

  • Investors should match their mutual fund selections with their risk tolerance and financial objectives.
  • Using metrics like the Information Ratio helps take a data-driven approach when choosing funds.

Final Thoughts

Well, the answer to the question at the beginning of the Blog are mutual funds worth the risk is actually depends on the risk appetite of the Investors. Tools like the Information Ratio offer insights into a fund’s performance and risk management abilities. By focusing on these metrics, investors can minimize uncertainty and make choices that align with their long-term goals. In conclusion, mutual funds can be a worthwhile investment if investors use metrics like the Information Ratio to assess their options. Zerodha’s insights emphasize the importance of combining education with investment strategies to effectively navigate the complexities of the financial markets.

Source – MF: Is your investment in a fund worth the risk? Zerodha explains information ratio on returns

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