Is your mutual fund too risky? Sebi's solution is risk-adjusted return'

Choosing a mutual fund can feel like picking a winning racehorse – you see past performance, but what about the risk involved? Market regulator Securities and Exchange Board of India (Sebi) has proposed a new system to help you make informed decisions.

What's the problem?

Right now, mutual funds advertise their returns, which is how much money you've made on your investment. But returns don't tell the whole story. Imagine two horses: one wins every race, but sometimes gets injured. The other is slower but finishes most races safely. The high-risk horse might have higher returns, but also a higher chance of losing money.

Introducing Risk-Adjusted Return (RAR):

Sebi is proposing a new rating called "Risk-Adjusted Return" (RAR). This considers both the return (your potential gain) and the risk (the chance of losing money) of a mutual fund. It's like a single score that tells you how much money the fund makes for each unit of risk it takes. A higher RAR means the fund is making good returns compared to the risk involved.

Imagine two mutual funds: Fund A delivers a 15% return, but its value fluctuates wildly throughout the year. Fund B offers a steadier 10% return. While Fund A seems more profitable, it also carries a higher risk of losing money.

A risk-adjusted return (RAR) rating considers both the return a fund offers and the risk it takes to achieve it. 

Risk-adjusted return (RAR) of a scheme portfolio quantifies the amount of return generated by a mutual fund scheme for each unit of risk taken to achieve that return.

The current regulatory framework does not mandate the disclosure of RAR along with the returns of an MF scheme.

There is no uniform practice followed by asset management companies (AMCs) regarding disclosure of RAR of their scheme.

Why is this important?

By knowing the RAR, you can compare different mutual funds more easily. You can choose a fund that fits your risk tolerance. If you're comfortable with taking more risks, you might choose a fund with a higher RAR, even if it has a slightly lower return. However, if you prefer a safer investment, you might choose a fund with a lower RAR but a more stable return.

Considering the significance of volatility of performance in determining the suitability of MF schemes, it is desirable that the RAR of the scheme is disclosed along with disclosure of its scheme performance, Sebi said in its consultation paper.

"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," it added.

How will this work?

Sebi is proposing a standard way to calculate RAR for different types of mutual funds. This will ensure all funds are rated on a level playing field. They're also asking for public feedback on the proposal before finalizing it.

What does this mean for you? 

This new system aims to empower investors by giving them more information to make informed choices. Once implemented, you can expect to see RAR displayed alongside returns when you research mutual funds. This will help you pick the right investment for your financial goals and risk tolerance.

SEBI's proposed RAR system is a step towards a more transparent and investor-friendly mutual fund market. By considering both return and risk, you can make smarter investment decisions and potentially achieve your financial goals faster.