Sebi’s new risk-adjusted return mandate: What it means for DIY investors

While this initiative aims to help investors make more informed decisions, a key question remains: will it truly benefit DIY (do-it-yourself) investors—those who manage their own portfolios without professional advisors—by enabling them to assess risk effectively and select the right funds?

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Two mutual fund schemes can generate identical returns yet offer vastly different experiences due to volatility, a widely accepted measure of risk. Evaluating returns without considering the risk taken to achieve them can be misleading. Several metrics exist to measure RAR, including the Sharpe Ratio, Treynor Ratio, and Sortino Ratio. 

However, Sebi has mandated the Information Ratio as the standardized metric for fund comparison.

Decoding the Information Ratio (IR)

The IR measures how much excess return a fund generates over its benchmark, adjusted for volatility. 

It is calculated as the difference between the portfolio return and the benchmark return, divided by the tracking error. The tracking error represents the standard deviation of the excess return. A higher IR indicates a fund manager’s ability to deliver consistent excess returns relative to the benchmark.

​IR serves as a comparative tool rather than an absolute performance measure. Sebi’s directive requires the Association of Mutual Funds of India (Amfi) to compile IR data from all asset management companies (AMCs) and publish it in a standardized, downloadable format. 

This enables investors to assess how consistently a fund has outperformed its benchmark and which fund offers better risk-adjusted returns. However, IR assumes that investors understand and accept the risks associated with equity investments.

Key considerations when using IR

While IR provides useful insights, it has limitations. 

A standalone IR value holds little meaning unless compared with others. The most effective use of IR is to rank funds against one another. It also varies over time, making it unsuitable for comparisons across different periods.

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Since IR is benchmark-sensitive, funds tracking different benchmarks cannot be directly compared. Additionally, a positive IR does not always indicate positive returns. A fund may have a positive IR even during a market downturn if it outperforms its declining benchmark.

The anomaly of negative IRs

A key challenge with IR, as with many RAR metrics, is how it handles negative values. 

Sebi’s consultation paper highlights an example where two funds, despite their actual performance, appear misleadingly ranked. 

Fund K, with an excess return of -1.11% and a tracking error of 4.08%, has an IR of -0.27. Fund L, with an excess return of -1.49% and a tracking error of 15.95%, has an IR of -0.09. 

At first glance, Fund L appears superior because -0.09 is mathematically greater than -0.27. However, Fund K actually has better returns and lower risk, making it the preferable option.

This anomaly arises because the IR formula does not accurately reflect performance when excess returns are negative. To address this, two approaches have been suggested. 

One option is to ignore the negative sign when IR is negative, but this method creates inconsistencies when comparing positive and negative IRs.

Another approach is to multiply excess return and tracking error instead of dividing them. Applying this method, Fund K’s adjusted IR becomes -4.529, while Fund L’s adjusted IR is -23.766. Under this calculation, Fund K ranks higher, accurately reflecting its superior performance. 

Since this anomaly exists across most RAR metrics, regulatory intervention may be required to standardize how negative IRs are handled.

Conclusion

Sebi’s mandate for IR disclosure is a step towards improving transparency and enabling investors to compare fund managers more effectively. However, IR alone is not enough—it does not directly reflect the risk of capital loss and should not be the sole basis for investment decisions.

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To make this data more accessible and actionable, online research platforms should integrate IR alongside other key metrics, allowing investors to filter and compare funds with ease. 

Ultimately, sound investment decisions require both data and judgment, and while IR is a valuable tool, it is just one part of a broader evaluation strategy.

Saurabh Mittal is the founding director of Circle Wealth Advisors Pvt. Ltd