SEBI Proposes Disclosure of Risk-Adjusted Return By Mutual Funds: Empowering Investor Decisions

Choosing a mutual fund often involves a balancing act between potential returns and risk. The Securities and Exchange Board of India (SEBI) is considering a proposal to make this decision easier for investors. This recent consultation paper seeks public feedback on mandating the disclosure of Risk-Adjusted Return (RAR) for mutual fund schemes.1 By providing a more comprehensive picture of a scheme’s performance by accounting for both risk and return, RAR disclosure could empower investors to make informed investment decisions.?

Background?

• Focus on Returns: Traditionally, return on investment has been the primary driver for investors choosing mutual funds. Asset Management Companies (AMCs) emphasize returns heavily when marketing their schemes.?

• Existing Disclosure Requirements: SEBI regulations (MF Regulations, 1996) and Master Circulars mandate AMCs to file periodic information on scheme performance, including return on investment, with SEBI. This information is disclosed in various documents:?

-Scheme Annual Report?

-Annual and Half-Yearly Financial Results?

-Scheme Information Document (SID)?

-Key Information Memorandum (KIM)?

• Disclosures Beyond Regulations: AMCs also disclose returns in various investor-facing documents, though not mandatory:?

-Abridged Annual Reports?

-Reports to Trustees?

-Fund Factsheets?

-Investor Account Statements?

-Product Notes?

• Need for Risk-Adjusted Return: While disclosures exist, risk-adjusted return (RAR) is considered a more insightful measure. RAR considers the risk level undertaken to achieve a specific return, providing a more holistic view of a scheme’s performance.?
• Gap in Regulations: The current regulatory framework does not mandate disclosure of RAR alongside regular returns.?

• Lack of Standardization: There is no uniform practice among AMCs regarding RAR disclosure for their mutual fund schemes.?

Current Industry Practice?

• Inconsistent Disclosure: Not all Asset Management Companies (AMCs) disclose RAR for all their mutual fund categories.?

• Varied Disclosure Channels: Some AMCs include RAR in monthly fund factsheets and marketing materials, but there is no standard practice.?

Lack of Standardization: AMCs use different methodologies to calculate RAR, impacting comparability between schemes. This applies to:

-Calculation frequency of RAR itself?

-Frequency of Net Asset Value (NAV) used in the calculation?

• Annualization Issue: Not all AMCs annualize the volatility (standard deviation) used in RAR calculations.?

Disclosure by Scheme Category is as follows:?

Issues for Public Consultation?

Issue 1: RAR Disclosure by Mutual Fund Schemes?

Issue: The consultation paper proposes mandating disclosure of RAR alongside scheme performance for mutual funds.?

Why RAR Matters??

• Volatility (performance fluctuations) is crucial in choosing suitable mutual funds.?

• RAR provides a more complete picture of a scheme’s performance by considering both return and risk.?

Information Ratio (IR) as the RAR Measure?

• The paper proposes using IR as the standard measure for RAR.?

• IR compares a scheme’s excess return (return above its benchmark) to the tracking error (volatility of excess return).?

How IR Works?

• IR is calculated as Tracking Difference (TD) divided by Tracking Error (TE).?

-TD: Excess return of the scheme portfolio compared to its benchmark.?

-TE: Volatility/standard deviation of the excess return. (Higher volatility = less consistent return & higher risk)?

• A scheme’s IR reflects its excess return relative to the benchmark while considering the risk taken. Thus, it represents the RAR.?

Benefits of Using IR?

• IR allows comparing RAR across different schemes within a category using a common benchmark.?

• A higher IR indicates better risk-adjusted performance compared to schemes with lower IR (assuming both use the same benchmark).?

Interpreting IR?

• Higher IR for a given volatility indicates the scheme achieved a higher excess return compared to others for the same level of risk.?

• Conversely, a higher IR for a given excess return suggests the scheme took less risk to achieve that return compared to others.?

Benefits of Disclosure?

• IR disclosure helps investors understand how efficiently a scheme generates returns relative to risk.?

• This provides a more comprehensive assessment of investment performance.?

• The proposal recommends mandating IR disclosure alongside scheme returns in all required documents (e.g., annual reports, factsheets).?

• It also suggests mandating IR disclosure for voluntarily disclosed performance information (e.g., digital platforms, marketing materials).?

Issue 2: Methodology to Calculate IR for different categories of Mutual Fund Schemes?

The consultation paper recognizes the lack of a standardized approach to volatility (risk) measurement in the industry. To ensure uniformity across mutual funds (MFs), it proposes specific methodologies for calculating IR based on the fund category.?

Current Situation?

• Most AMCs don’t disclose volatility due to the absence of a mandatory requirement.?

• Existing disclosures (if any) use varied methods for calculating volatility/sensitivity.?

Proposed Measures for Uniformity?

1. Equity, Hybrid, Solution-Oriented, and Fund of Funds Schemes?

• IR calculation:?

-(Portfolio Rate of Return - Benchmark Rate of Return) / Standard Deviation of Excess Return?

-Excess Return = Portfolio Rate of Return - Benchmark Rate of Return?

-Benchmark: Tier 1 benchmark currently used by equity-oriented MFs.?

2. Debt-Oriented Mutual Fund Schemes?

• IR calculation method: Same as equity-oriented schemes.?

• Benchmark: Varies depending on the debt scheme category and its respective Tier 1 benchmark.?

3. ETFs and Index Funds?

• Existing disclosure requirements for Tracking Error (TE) and Tracking Difference (TD) are considered sufficient for volatility disclosure.?

• No separate IR calculation proposed for these categories.?

Note: An illustrative explanation of the IR calculation methodology is provided in Annexure A of the consultation paper.?

Issue 3: Frequency of IR Disclosure?

The consultation paper proposes that IR could be calculated and disclosed daily on the websites of AMCs and AMFI, along with potentially being included in all other platforms where scheme information is provided (e.g., SID, KIM).?

Issue 4: Applicability of IR Disclosure to New Schemes?

The paper seeks comments on how IR disclosure should be handled for new schemes:?

• No Disclosure for Schemes < 6 Months Old: Currently, past performance disclosure is not mandatory for schemes under six months old. The proposal suggests potentially extending this exemption to IR disclosure as well.?

• Annualized IR for Schemes 6-12 Months Old: Schemes between six months and one year old might disclose IR based on annualized returns for the past six months. This aligns with the current practice for past performance disclosure.?

Issue 5: Format to Disclose IR?

The consultation paper proposes that AMFI, in consultation with SEBI, develop a standardized format for disclosing the Information Ratio (IR) across various platforms. However, a sample of the format is provided in the Paper.?

Conclusion and The Way Forward?

SEBI’s proposal for mandatory Risk-Adjusted Return (RAR) disclosure using a standardized Information Ratio (IR) has the potential to empower investors. While IR disclosure can improve decision-making, comparability, and focus on investment efficiency, challenges include potential misinterpretation by less informed investors due to the quantitative nature of IR and information overload from daily disclosures. Additionally, applicability of IR to new schemes needs consideration. Overall, the proposal represents a significant step towards a more informed investor base, but successful implementation hinges on addressing potential drawbacks through investor education, optimized disclosure frequency, and potentially including volatility measures for young schemes.?