CAGR is merely returns of a fund based on its NAV.
For a more holistic measure of a mutual fund’s performance, the Securities and Exchange Board of India (Sebi) has asked asset management companies (AMCs) to disclose Risk Adjusted Returns (RAR) of their schemes, a move aimed at giving the investor a clearer picture of a fund’s returns.
Until now, compounded annual growth rate (CAGR), which measures the annualised growth rate of a mutual fund over a period, has been the preferred metric for showcasing returns by AMCs.
According to the capital markets regulator, disclosure of Information Ratio (IR) as a financial metric to measure the RAR of a scheme portfolio will bring in more transparency in disclosures made by AMCs and aid better decision making by investors.
RAR disclosure will only be applicable for equity-oriented schemes, the January 17 circular has said.
How the RAR is calculated?
To bring uniformity across AMCs, RAR will be calculated as follows:
RAR = Fund returns minus benchmark returns divided by standard deviation of excess return. Excess returns will be calculated as fund returns minus benchmark returns, Sebi has used.
The benchmark used in the formula will be the Tier 1 benchmark used by equity-oriented funds.
Story continues below Advertisement
Volatility, or standard deviation, will be calculated on the basis of daily return values based on the net asset value (NAV).
Also read | Mind The Gap: Fund manager of Rs 66,000-cr scheme warns of potential earnings mismatch
For mutual funds, standard deviation is a measure of how volatile a fund’s returns have been over a period, essentially showing how much the returns deviated from the average return.
Is RAR a better metric than CAGR?
According to experts, RAR tells investors how much risk was taken to deliver certain returns and how consistently were those returns delivered.
“Let’s say the benchmark return is 12 percent and the fund has delivered 15 percent returns. This means the scheme has delivered 3 percent excess return over and above the benchmark. Now how much is the risk? It is standard deviation in this case, meaning how much risk was taken by the fund to deliver this 3 percent excess return on a consistent basis. This 3 percent return is divided by standard deviation of the 3 percent returns,” said Kirtan Shah, founder of Credence Wealth Advisors.
For a better understanding, let’s take an example of two funds.
Formula: RAR = Excess return/tracking error.
Excess return = Fund return−benchmark return.
Tracking error = Standard deviation of excess return over the evaluation period.
Fund A:
• Excess return: 2 percent
• Tracking error: 5 percent
• RAR of Fund A = 2/5= 0.4
Fund B:
• Excess return: 3 percent
• Tracking error: 8 percent
• RAR of Fund B = 3/8 = =0.375
Since a higher RAR indicates better risk-adjusted performance relative to the benchmark, Fund A has a slightly higher performance.
“CAGR is merely returns of a fund based on its NAV. The RAR is the excess returns a fund generates over benchmark for a unit of risk taken. It thus tells whether the fund delivers higher than benchmark for a given risk. CAGR does not give any relative comparison,” said Vidya Bala, co-founder, PrimeInvestor.in.
Also read | How to turn your passion into a plan
Are there limitations to RAR?
One limitation of RAR, said Shah, is that it takes into consideration the risk on the excess returns over the benchmark and not the standard deviation of the entire returns, which is the case with the Sharpe Ratio.
Experts also say RAR is not easy to understand for a lay investor.
“What if a large-cap fund had a higher RAR than a multi-cap fund? Is it superior? Not necessarily, as they are compared with different benchmarks. We would instead recommend looking at consistency in outperformance, which can be known with a simple proportion of outperformance of the benchmark on a rolling return basis over three or five years,” said Vidya Bala, co-founder, Primeinvestor.in.
High returns can mask risks. “One needs to look at additional metrics such as downside ratio or worst drawdowns to understand risks. RAR can mask this in prolonged bull rallies,” she added.
Also read | Can CoinSwitch’s Rs 600-crore plan help WazirX investors recover their losses?
The right way to use RAR
Financial experts are unanimous in suggesting RAR to investors over CAGR.
“The risk adjusted return is definitely a much better metric, especially to compare across categories. This was a problem, which most investors have been labouring under,” said Suresh Sadagopan, a Sebi-registered investment adviser and principal officer at Ladder7 Wealth Planners.
RAR, however, cannot be a one-stop solution for selecting a fund. Investment horizon and risk profile remain the building blocks of an investment portfolio.
Within equity, whether you should go for a large-cap, multi-cap or flexi-cap and so on depends on your risk-taking ability and the time for holding the investment.
“After you have done this exercise, you then take a look at the kind of past performance in CAGR terms as well as RAR. If all things remain constant, one should choose a scheme that has delivered similar returns with a lower degree of risk,” said Amol Joshi, the founder of Plan Rupee Investment Services.
Also read | Specialised investment fund: How this new asset class will work and help investors
“RAR should not be your first filter. RAR can help you zero in on your fund after shortlisting four or five funds,” Joshi said.
To ensure better understanding, Sebi has asked AMCs and the Association of Mutual Funds in India (AMFI) to educate investors about its significance in evaluating a scheme.
These provisions come into effect within three months of the circular being issued.