Sebi’s Information Ratio (IR)

Context:

Securities and Exchange Board of India (Sebi) has taken a significant step toward enhancing mutual fund (MF) transparency by introducing the daily disclosure of the Information Ratio (IR) for all MFs. The regulation is prescribed in a circular and shall come into effect three months from the date of issuance.

Purpose

The purpose of this regulation is to assist DIY (do it yourself) investors in making informed decisions by using a transparent system to measure risk adjusted returns (RAR). However, it has still raised some fundamental questions about whether the IR is of practical use to individual investors.

What actually is the Information Ratio (IR)?

The IR measures the excess return of a fund with respect to its benchmark through the lens of volatility.

The formula:

IR = (Portfolio Return – Benchmark Return) / Tracking Error

Higher IR → A fund manager is delivering more consistent excess returns relative to the benchmark.

Sebi has assigned the Association of Mutual Funds of India (Amfi) the task of collecting the IRs published by all Asset Management Companies (AMCs) after standardizing them and providing them in a downloadable format.

Key Advantages of IR Disclosure

• Comparability Is Enhanced
  • Investors can rank mutual funds according to their respective risks and returns.
• Transparency
  • Allows investors to see which fund managers generate excess returns on a consistent basis.
• Decision Enhancement
  • Provides a standardized measure for quantifying funds beyond simple returns.

Limitations & Challenges

• Is Meaningless in Isolation
  • IR makes sense only in comparison to that of other funds. It does not say much to the investor about whether a fund is good or bad when taken on its own.
• Indeterminate from a Time Perspective
  • IR is subject to variable fluctuation over time, thus rendering it unfit for comparisons in a long run.
• Sensitivity to Benchmark Change
  • Funds following different benchmarks cannot be compared with respect to their IR, and thus IR cannot be the sole measure.
• May Have a Positive IR Even in a Down Market
  • A positive IR may occur when the fund outperforms a benchmark in decline, despite declining returns.
• Negative IR Contradiction
  • One of the primary problems of the IR is that it treats negative excess returns in such a way as to obtain results that could be very misleading when it comes to ranking.

• Example from Sebi’s Consultation Paper
  • Fund K:
    • Excess Return: 1.11%
    • Tracking Error: 4.08%
    • IR: 0.27
  • Fund L:
    • Excess Return: 1.49%
    • Tracking Error: 15.95%
    • IR: 0.09

• Misleading Ranking:
• Judging by the IR alone, Fund L (0.09 IR) appears better than Fund K (0.27 IR); however, Fund K delivered higher returns with correspondingly much less risk, making it the better choice.

Suggested Solutions

• Ignoring the Negative Sign in IR (This will create inconsistencies for comparing positive IRs and negative ones).
• Considering the Multiplication of Excess Return & Tracking Error Instead of Its Division
  Adjusted IR rankings would better reflect actual fund performance.

In light of the existence of negative IR distortions in several other risk adjusted return (RAR) measures, Sebi may need to step in and standardize the treatment of any such issues.