A large number of Mutual Fund investors pick funds that have given high returns in the past. However, many of them have no idea about the kind of risks their chosen funds have taken to deliver such returns. In the absence of such information, investors often end up exposing their investments to extreme risks. This is also a missing link in the MF value chain as not all fund houses publicly share the risks they have taken to deliver high returns. But, don’t worry. SEBI has a solution for this – Making disclosure of Risk-adjusted Return (RAR) mandatory for all mutual funds. 

In a recent consultation paper, the Securities and Exchange Board of India (SEBI) proposed that mutual funds should disclose risk-adjusted returns (RAR) to offer a clearer view of performance. by highlighting both returns and the risks involved.

“It is felt that the ‘Risk Adjusted Return’ (RAR) of a scheme portfolio represents a more holistic measure of the scheme’s performance because it quantifies the amount of return generated by a MF scheme for each unit of risk taken to achieve that return”, SEBI says in the paper. 

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SEBI noticed that while some fund houses disclose RAR, the methods used vary between them. Additionally, not all fund houses provide RAR figures. For example, among the 39 fund houses with equity schemes, only 33 disclose RAR, and among the 36 with hybrid schemes, only 27 disclose these figures.

What is a Risk-Adjusted Return (RAR)?

“Risk-Adjusted Return” (RAR) measures the potential gain (return) and the risk (likelihood of losing money) associated with a mutual fund. It gives a single score that shows how effectively the fund generates profits compared to the risks taken. A higher RAR indicates that the fund achieves better returns relative to the risks involved.

Imagine two mutual funds: Fund A earns a 15% return but experiences significant price swings. Meanwhile, Fund B offers a more consistent 10% return. While Fund A might seem more profitable, it also carries a higher risk of losing money.

A risk-adjusted return (RAR) rating takes into account both the return a fund generates and the risk it assumes to achieve that return.

RAR quantifies how much return a mutual fund scheme generates per unit of risk undertaken. Currently, regulatory requirements do not mandate the disclosure of RAR alongside fund returns.

Asset management companies (AMCs) do not follow a standardized practice for disclosing RAR across their schemes.

Importance of Risk-Adjusted Return (RAR)?

Understanding the RAR helps you compare mutual funds effectively. It allows you to select a fund that matches your risk tolerance. If you’re willing to take on more risk, you might opt for a fund with a higher RAR, even if its return is slightly lower.

However, if you prefer a safer investment, you might choose a fund with a lower RAR but a more consistent return.

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“Information Ratio (IR) is an established financial ratio to measure the RAR of the scheme portfolio. It is often used as a measure of a 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, or standard deviation component into the calculation”, says SEBI.

This initiative aims to empower investors with better information for making informed decisions. Once implemented, RAR will be displayed alongside returns when you research mutual funds, helping you choose investments that align with your financial goals and risk tolerance.

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Disclaimer: The above content is for informational purposes only. Please consult a SEBI-registered investment advisor before investing.