📚 PASS Investment Adviser (Level 1) Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 19.3 — Ethical issues for an Investment Adviser

Imagine you are reviewing two mutual fund schemes for a client’s portfolio. Fund A has delivered a stellar 18% absolute return over the past three years, while Fund B has returned a more modest 14%. A novice might immediately recommend Fund A, but a seasoned advisor knows that absolute numbers often mask the volatility endured to achieve those gains. Risk-adjusted returns allow us to normalize this performance by measuring how much excess return was generated per unit of risk taken, usually defined by standard deviation or beta.

In the Indian financial context, where market volatility can be significant, evaluating performance without adjusting for risk is a recipe for unsuitable advice. We use metrics like the Sharpe Ratio to determine if a manager is creating genuine alpha or simply taking excessive exposure to market-wide or security-specific risks. If Fund A achieved its 18% return by betting heavily on a handful of volatile mid-cap stocks, while Fund B maintained a diversified, lower-volatility portfolio, the latter might actually be the superior investment when considering the client’s risk appetite.

Consider the case of two Debt Funds: a Gilt Fund and a Corporate Bond Fund. If both report similar returns, the Gilt Fund is likely the more efficient vehicle because it carries minimal credit risk compared to the corporate offering. By looking at risk-adjusted metrics, an advisor can determine if a product provides ‘value for money’ regarding the risk premium earned. This analytical rigor is what separates a mere product seller from a fiduciary who acts in the client’s best interest.

Ultimately, incorporating risk-adjusted metrics into your workflow prevents the ‘chasing returns’ trap. It forces you to ask whether a high-performing product is actually sustainable or if it is merely riding a lucky streak at the expense of potential downside. When you present this data to a client, you shift the conversation from mere speculation to a professional, objective assessment of their financial goals.

Nuance

⚠️ Nuance
Candidates often confuse ‘return’ with ‘performance,’ erroneously assuming that the highest return is synonymous with the best investment. This trap leads to recommending high-beta products during bull markets without accounting for the impending correction. A professional analyst must view a return as a price paid for the risk taken; if the risk-adjusted reward is insufficient, the investment fails the suitability test, regardless of its recent market performance.

Check Your Understanding

Practice Question 1

An advisor is comparing two equity funds for a client with a conservative profile. Fund X has an annualized return of 15% with a standard deviation of 20%, while Fund Y has an annualized return of 12% with a standard deviation of 10%. Assuming the risk-free rate is 6%, which fund offers a better risk-adjusted return?

Practice Question 2

Why does an advisor use the Sortino Ratio instead of the Sharpe Ratio when evaluating a portfolio with significant downside risk?

This is a companion read for Section 19.3 — Ethical issues for an Investment Adviser from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

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