The capital market regulator in June last year released a consultation paper for disclosure of Risk-Adjusted Returns (RAR) by mutual funds, intended to enable investors to make informed decisions.

The reason behind this was that most investors while zeroing in on schemes look at only returns — compounded annualised returns or absolute returns (as the case may be) — often ignoring the risk involved and disregarding the point that past returns are in no way indicative of future returns.

Ideally, investors should also consider the risk taken by the fund to clock the returns, as for every level of return you seek, there is a certain level of risk as well.

“The essence of investment management is the management of risks, not the management of returns,” said Benjamin Graham, the father of value investing and Warren Buffet’s mentor.

As an investor, you also need to be mindful of the risk involved in mutual fund schemes and not just go by the historical returns clocked. Simply going by returns may not be in the best interest of your financial well-being.

Recognising that risk plays a critical aspect when making investment decisions, SEBI has now mandated that Asset Management Companies (AMCs) or mutual fund houses disclose periodic performance of mutual fund schemes along with the ‘Risk-Adjusted Return’ (RAR).

[Read: 7 Ratios to Assess Mutual Fund Risk]

RAR is an important parameter that helps determine how much excess returns were generated by the portfolio for each unit of risk taken. If the fund clocks a higher RAR, it perhaps also indicates that the fund manager took a higher risk to clock better returns. According to the regulator, RAR represents a holistic measure of the scheme’s performance.

SEBI wants AMCs of mutual fund houses to mandatorily disclose the Information Ratio (IR) for all equity-oriented mutual fund schemes (along with the performance disclosures) on their website on a daily basis. In addition, the regulator has also directed the Association of Mutual Funds in India (AMFI) to ensure that such disclosures are made available on its website in a comparable, downloadable and machine-readable format.

“Considering the significance of volatility of performance in determining the suitability of mutual fund schemes, Information Ratio is an established financial ratio to measure the risk-adjusted return of any scheme portfolio,” the SEBI note said.

What Is the Information Ratio?

The Information Ratio (IR) is a measure of the portfolio manager’s level of skill and ability to generate excess returns relative to a benchmark, and it also attempts to identify the consistency of the performance by incorporating a Tracking Error (TE), or Standard Deviation (SD) component into the calculation.

The SD measures the volatility representing the deviation of the return of security around its mean return. The higher the SD, the higher the risk to the underlying portfolio carries and vice versa.

The TE of the fund is the Standard Deviation of the difference between the fund’s returns and the index returns.

SEBI has shared a standard formula for AMCs to calculate IR for uniformity purposes:

IR = (Portfolio Rate of Returns less Benchmark Rate of Returns) ÷ Standard Deviation of Excess Return

Excess Return is calculated by subtracting the Benchmark Return from the Portfolio Return (i.e. Portfolio Return – Benchmark Return).

To calculate the Excess Return, SEBI has clarified that the Tier 1 benchmark currently tracked by the equity-oriented mutual fund scheme should be used.

As an investor, you need to keep in mind that if a mutual fund scheme carries a higher IR, it indicates that the fund manager is more consistent in generating returns relative to the benchmark. In other words, a mutual fund scheme with a high IR could be preferred over a scheme with a lower IR, provided that the performance of both schemes is being compared to the same benchmark under a particular sub-category of equity-oriented funds.

In the interest of investors at large, the regulator has directed all AMCs or mutual fund houses and AMFI to take the initiative to educate investors about RAR, IR and their importance in scheme evaluation. The regulator has said that allocation should be made from the budget for investor education, leveraging on social and mass media channels to maximise the outreach and impact.

To understand various other ratios to evaluate mutual funds, watch this video:

To conclude…

SEBI’s diktat of mandatory disclosure of RAR vide the IR is a positive step, empowering investors to adopt a holistic approach and make an informed investment decision.

When evaluating the performance of a mutual fund scheme, while returns play an important role, look for consistency in generating returns by assessing how the scheme fares on RAR and performance across market cycles. Avoid looking at returns in silos. Understanding key risk ratios enables you to thoughtfully evaluate mutual fund schemes.

Also, note that while returns and risks are considered to be two sides of the same coin, it is not always that high risk translates into high returns.

The formulas that try to capture risk have limitations, as often the benchmark index undergoes frequent changes.

Moreover, there are various undercurrents or factors, such as macroeconomic and geopolitical that may wreak risk to on the underlying portfolio holdings of the mutual fund scheme and may have nothing to do with the fundamentals per se of the company.

For example, now with news of Trump 2.0 levying high tariffs, practising stringent immigration rules, and DeepSeek (a low-cost Chinese AI model that could change the face of AI and reduce the dominance of global AI leaders), among others doing the rounds, the sentiments in the Indian equity market have been hit and may not have anything necessarily to do with the present fundamentals of the stocks in the portfolio, if they are of worthy quality.

So, it is important to assess the portfolio characteristics of a mutual fund for its quality to understand the possible risks involved.

It is also crucial to recognise the fund manager’s ability to consistently outperform the benchmark and set your return expectations right. In this regard, it would be wise to evaluate the fund manager’s track record.

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

Invest in mutual fund schemes that are not just the best on past returns but have the potential to fare decently even in the future by managing the risks sensibly.

It would also be beneficial to understand the investment process and systems followed at the fund house.

Choose a mutual fund scheme that is not just best on returns and risk-adjusted returns, but also that is the most suitable one for you, that aligns well with your risk profile, broader investment objective, the financial goal/s you plan to address, and the time in hand to achieve those envisioned goals.

Be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here