SEBI’s recent consultative paper on risk-adjusted returns recommends that asset management companies (AMCs) disclose information ratio (IR) of their funds. In this article, we discuss how IR could help individuals with their investment choices.

Uniform metric

The number of AMCs has increased over the years. With availability of multiple products comes the difficulty of making meaningful choices. It is in this context that you must weigh IR.

An active fund is expected to generate alpha or excess returns over its benchmark index. Every active manager must take risks to generate alpha. Typically, you want to invest in a fund that generates consistent alpha. So, the volatility (fluctuation) of alpha is considered as a risk measure. If you divide a fund’s alpha by the volatility of its alpha, you get IR.

You must consider two arguments before applying IR as a risk-adjusted metric. One, the objective is not to select a fund with the highest IR. Rather, the intention is to select a fund that has statistically significant IR. This requires an analyst to conduct a t-test. It is moot if individuals will conduct such a statistical test. It will, therefore, help the investors if funds disclose their IRs over one-, three-, five- and 10-year periods. In addition, funds existing for more than 10 years must be required to report their IR since fund inception. This will enable investors to gauge the consistency of a fund’s IR. Typically, the more consistent an IR, the greater the confidence that the fund will be able to sustain its alpha in the future.

Two, the usefulness of IR depends on an accurate determination of alpha, which depends on the validity of its benchmark. In effect, you are determining if the fund is investing within its benchmark index. Current regulation allows equity funds to drift from their benchmark. A large cap fund, for instance, can invest up to 20% outside of large caps. So, alpha, measured as the difference between the fund and its benchmark, cannot be considered as global best practice measure. The disclosure of IR will be more meaningful if the benchmark truly reflects a fund’s complete investment universe.

Conclusion

IR as a metric is meaningful when you want to invest surplus savings in an equity fund. It is more appropriate to use Sortino Ratio if you are investing in a fund to achieve a life goal. But that is best left for a later discussion.

(The author offers training programmes for individuals to manage their personal investments)

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