Risk-Adjusted Performance: A Reliable Guide to Investor Skill

A common mistake made by novice investors is to focus solely on the return of an investment without considering its risks. They tend to home in on recent results, which typically come with a disclaimer that “past performance is not indicative of future performance”.

The quandary the disclaimer poses is that an investment manager’s performance track record is the only thing potential investors have to go on. However, there is a way to approach past performance to gauge a manager’s skill and get an idea of how well the manager will not only grow your money in the future but protect you against market shocks. It’s by looking at what is known as risk-adjusted performance.

Comparing two funds investing in the same asset class, let’s say Fund A returned 15% over 12 months, while Fund B returned 10%. Was Fund A’s manager more skilful in choosing the underlying investments, or did the manager happen to choose riskier investments that paid off over the short term?

To more reliably gauge an investment manager’s skill one must look not only at performance over a longer term (preferably five years or longer), but at the consistency of that performance, or, in statistical terms, the extent to which the returns deviate from the investment’s average return of the period.The more returns deviate from the average, or mean, the more volatile the investment is and the less consistent the outcome will be. This applies particularly to stock-market investments such as equity funds.

A certain amount of risk is necessary to achieve higher returns. Portfolio managers thus aim for a balance between risk and return that, while possibly tempering returns over the short term, ensures more consistent, reliable performance over longer periods.

Risk-adjusted performance

Risk-adjusted performance is a measure of an investment’s returns against its volatility. Two ratios commonly used in the investment industry are the Sharpe Ratio and the Sortino Ratio.

The Sharpe Ratio was developed in the 1960s by US economist William F Sharpe. It is calculated by dividing what the fund has returned above the “risk-free rate” in a given period by its volatility (deviation from the mean, or standard deviation in statistical terms). The risk-free rate is the return you would get on a virtually zero-risk investment such as a government bond.

As an example, let’s again look at Funds A and B, but over five years instead of one. Fund A’s annualised return over five years is 16% and its standard deviation is 12%. Fund B’s return is 14% and its standard deviation is 7%. The risk-free rate in both cases is 10%.

Fund A: (16% − 10%) ÷ 12% = 0.50

Fund B: (14% − 10%) ÷ 7% = 0.57

Fund B has the lower annualised return but a higher Sharpe Ratio, translating into a higher risk-adjusted return.

A 2012 study found that Warren Buffett’s investment company Berkshire Hathaway had a Sharpe Ratio of 0.76 over the 35 years 1976 to 2011, compared with the US stock market’s 0.39 for the same period.

The Sortino Ratio is a variation of the Sharpe Ratio that takes into account only downside deviation from the mean, which is detrimental to overall returns, unlike upside deviation.

In a blog for global asset manager BlackRock, Daniel Prince, managing director of Blackrock’s iShares division, likens risk-adjusted return to driving at the speed limit towards a certain destination. “You can get there faster if you’re willing to drive above the speed limit. The faster you go, the quicker you could arrive. However, going above the speed limit increases your risk of getting a ticket, having to swerve wildly to avoid accidents, or something worse. The faster you go, the higher the odds of a bad outcome,” Prince says.

He says that having a diversified portfolio optimised for risk-adjusted returns may feel like a slow, even boring, approach that means it could take longer to reach your destination. But you increase the odds of getting there safely.

A manager’s view

The importance of considering risk-adjusted returns is well summed up by Cornelius Zeeman, equity portfolio manager at Cape-Town-based asset manager Fairtree. “Not all returns are equal. Investments with high returns may come with high volatility. Risk-adjusted returns highlight how much risk is associated with achieving those returns, which can be crucial for making informed decisions. A fund that delivers consistent, robust returns relative to the risks taken demonstrates disciplined investment management, a repeatable process, effective diversification, and resilience in varying market conditions. This approach protects capital during market downturns and positions portfolios to take advantage of opportunities. Selecting a fund with a strong track record of risk-adjusted returns is an essential step towards sustainable wealth creation,” Zeeman says.

References:

https://www.blackrock.com/ca/investors/en/risk-adjusted-return

https://www.investopedia.com/terms/r/riskadjustedreturn.asp