Measures Risk
There are five main indicators of investment risk that apply to the analysis of stocks, bonds
and mutual fund portfolios. They are alpha, beta, r-squared, standard deviation and the Sharpe
ratio. These statistical measures are historical predictors of investment risk/volatility and they are
all major components of modern portfolio theory (MPT). MPT is a standard financial and
academic methodology used to assess the performance of equity, fixed-income and mutual fund
investments by comparing them to market benchmarks. All of these risk measurements are
intended to help investors determine the risk-reward parameters of their investments. Here is a
brief explanation of each of these common indicators.
Alpha
Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility
(price risk) of a security or fund portfolio and compares its risk-adjusted performance to a
benchmark index. The excess return of the investment relative to the return of the benchmark
index is its alpha. Simply stated, alpha is often considered to represent the value that a portfolio
manager adds or subtracts from a fund portfolio's return. An alpha of 1.0 means the fund has
outperformed its benchmark index by 1%. Correspondingly, an alpha of -1.0 would indicate
an under-performance of 1%. For investors, the higher the alpha the better.
Beta
Beta, also known as the beta coefficient, is a measure of the volatility, or systematic risk, of a
security or a portfolio compared to the market as a whole. Beta is calculated
using regression analysis and it represents the tendency of an investment's return to respond to
movements in the market. By definition, the market has a beta of 1.0. Individual security and
portfolio values are measured according to how they deviate from the market.
A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta
of less than 1.0 indicates that the investment will be less volatile than the
market. Correspondingly, a beta of more than 1.0 indicates that the investment's price will be
more volatile than the market. For example, if a fund portfolio's beta is 1.2, it is theoretically
20% more volatile than the market.
Conservative investors who wish to preserve capital should focus on securities and fund
portfolios with low betas while investors willing to take on more risk in search of higher returns
should look for high beta investments.
R-squared
R-squared is a statistical measure that represents the percentage of a fund portfolio or a security's
movements that can be explained by movements in a benchmark index. For fixed-income
securities and bond funds, the benchmark is the U.S. Treasury Bill. The S&P 500 Index is the
benchmark for equities and equity funds.
R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-
squared value between 85 and 100 has a performance record that is closely correlated to the
index. A fund rated 70 or less typically does not perform like the index.
Mutual fund investors should avoid actively managed funds with high R-squared ratios, which
are generally criticized by analysts as being "closet" index funds. In such cases, it makes little
sense to pay higher fees for professional management when you can get the same or better results
from an index fund.
Standard Deviation
Standard deviation measures the dispersion of data from its mean. Basically, the more spread out
the data, the greater the difference is from the norm. In finance, standard deviation is applied to
the annual rate of return of an investment to measure its volatility (risk). A volatile stock would
have a high standard deviation. With mutual funds, the standard deviation tells us how much the
return on a fund is deviating from the expected returns based on its historical performance.
Sharpe Ratio
Developed by Nobel laureate economist William Sharpe, the Sharpe ratio measures risk-
adjusted performance. The Sharpe ratio is used to help investors understand the return of an
investment compared to its risk. The ratio is the average return earned in excess of the risk-free
rate per unit of volatility or total risk.
It is calculated by subtracting the risk-free rate of return from the rate of return for an investment
and dividing the result by the investment's standard deviation of its return. The Sharpe ratio tells
investors whether an investment's returns are due to wise investment decisions or the result of
excess risk. This measurement is useful because while one portfolio or security may generate
higher returns than its peers, it is only a good investment if those higher returns do not come with
too much additional risk. The greater an investment's Sharpe ratio, the better its risk-adjusted
performance.
Subtracting the risk-free rate from the mean return allows an investor to better isolate the profits
associated with risk-taking activities. Generally, the greater the value of the Sharpe ratio, the
more attractive the risk-adjusted return.
By quantifying both volatility and performance, this tool allows for an incremental
understanding of the use of risk to generate return
Here is the standard Sharpe ratio equation:
Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio
return, or,
S(x) = (rx - Rf) / StandDev(x)
To recreate this formula in Excel, create a time period column and insert values in ascending
sequential order (1, 2, 3, 4, etc). Each time period is usually representative of either one month or
one year. Then, create a second column next to it for returns and plot those values in the same
row as their corresponding time period.
In the third column, list the risk-free return value, which is normally the current returns for U.S.
Government Treasury bills. There should be the same value in every row in this column.
A fourth column has the equation for excess return, which is the return minus the risk-free
return value. Use the cells in the second and third columns in the equation. Copy this equation
into each row for all time periods.
Next, calculate the average of the excess return values in a separate cell. In another open cell, use
the =STDEV function to find the standard deviation of excess return. Finally, calculate the
Sharpe ratio by dividing the average by the standard deviation. Higher ratios are considered
better.
The Bottom Line
Many investors tend to focus exclusively on investment returns with little concern for investment
risk. The five risk measures we have discussed can provide some balance to the risk-return
equation. The good news for investors is that these indicators are calculated for them and are
available on a number of financial websites: they are also incorporated into many
investment research reports. As useful as these measurements are, when considering a stock,
bond, or mutual fund investment, volatility risk is just one of the factors you should be
considering that can affect the quality of an investment.
Ways to Rate Your Portfolio Manager
The overall performance of your portfolio is the ultimate measure of success for your portfolio
manager. However, total return cannot exclusively be used when determining whether or not
your money manager is doing his or her job effectively.
For example, a 2% annual total portfolio return may initially seem small. However, if the market
only increased by 1% during the same time interval, then the portfolio performed well compared
to the universe of available securities. On the other hand, if this portfolio was exclusively
focused on extremely risky micro-cap stocks, the 1% additional return over the market does not
properly compensate the investor for risk exposure. To accurately measure performance, various
ratios are used to determine the risk-adjusted return of an investment portfolio. We'll look at the
five common ones in this article.
Sharpe Ratio : (expected return – risk free return)/portfolio standard deviation
The Sharpe ratio, also known as the reward-to-variability ratio, is perhaps the most common
portfolio management metric. The excess return of the portfolio over the risk-free rate is
standardized by the standard deviation of the excess of the portfolio return. Hypothetically,
investors should always be able to invest in government bonds and obtain the risk-free rate of
return. The Sharpe ratio determines the expected realized return over that minimum. Within the
risk-reward framework of portfolio theory, higher risk investments should produce high returns.
As a result, a high Sharpe ratio indicates superior risk-adjusted performance.
For more, see: Understanding the Sharpe Ratio.
Many of the ratios that follow are similar to the Sharpe in that a measure of return over a
benchmark is standardized for the inherent risk of the portfolio, but each has a slightly different
flavor that investors may find useful, depending on their situation.
Roy's Safety-First Ratio (Expected Return - Target Return) / Portfolio Standard Deviation
Roy's safety-first ratio is similar to the Sharpe but introduces one subtle modification. Rather
than comparing portfolio returns to the risk-free rate, the portfolio's performance is compared to
a target return.
The investor will often specify the target return based on financial requirements to maintain a
certain standard of living, or the target return can be another benchmark. In the former case, an
investor may need Rs50,000 per year for spending purposes; the target return on a Rs1 million
portfolio would then be 5%. In the latter scenario, the target return may be anything from the
S&P 500 to annual gold performance – the investor would have to identify this target in
the investment policy statement.
Roy's safety-first ratio is based on the safety-first rule, which states that a minimum portfolio
return is required, and that the portfolio manager must do everything he or she can in order to
ensure this requirement is met.
Sortino Ratio : ( Expected Return – Target Return) / Downside Standard Deviation
The Sortino ratio looks similar to the Roy's safety-first ratio – the difference being that, rather
than standardizing the excess return over the standard deviation, only the downside volatility is
used for the calculation. The previous two ratios penalize upward and downward variation; a
portfolio that produced annual returns of +15%, +80% and +10%, would be perceived as fairly
risky, so the Sharpe and Roy's safety-first ratio would be adjusted downward.
The Sortino ratio, on the other hand, only includes the downside deviation. This means only the
volatility that produces fluctuating returns below a specified benchmark is taken into
consideration. Basically, only the left side of a normal distribution curve is considered as a risk
indicator, so the volatility of excess positive returns are not penalized. That is, the portfolio
manager's score isn't hurt by returning more than was expected.
Treynor Ratio : ( Expected Return – Risk Free Return ) / Portfolio Beta
The Treynor ratio also calculates the additional portfolio return over the risk-free rate.
However, beta is used as the risk measure to standardize performance instead of standard
deviation. Thus, the Treynor ratio produces a result that reflects the amount of excess returns
attained by a strategy per unit of systematic risk. After Jack L. Treynor initially introduced this
portfolio metric, it quickly lost some of its luster to the now more popular Sharpe ratio.
However, Treynor will definitely not be forgotten. He studied under Italian economist Franco
Modigliani and was one of the original researchers whose work paved the way for the capital
asset pricing model.
Because the Treynor ratio bases portfolio returns on market risk, rather than portfolio-specific
risk, it is usually combined with other ratios to give a more complete measure of performance.
Information Ratio : ( Portfolio Return – Benchmark Return ) / Tracking Error
The information ratio is slightly more complicated than the aforementioned metrics, yet it
provides a greater understanding of the portfolio manager's stock-picking abilities. In contrast
to passive investment management, active management requires regular trading to outperform
the benchmark. While the manager may only invest in S&P 500 companies, he may attempt to
take advantage of temporary security mispricing opportunities. The return above the benchmark
is referred to as the active return, which serves as the numerator in the above formula. (For
related reading, see Choose a Fund With a Winning Manager.)
In contrast to the Sharpe, Sortino and Roy's safety-first ratios, the information ratio uses the
standard deviation of active returns as a measure of risk instead of the standard deviation of the
portfolio. As the portfolio manager attempts to outperform the benchmark, he or she will
sometimes exceed that performance and at other times fall short. The portfolio deviation from
the benchmark is the risk metric used to standardize the active return.
The Bottom Line
The above ratios essentially perform the same task: They help investors calculate the excess
return per unit of risk. Differences arise when the formulas are adjusted to account for different
kinds of risk and return. Beta, for example, is significantly different from tracking-error risk. It is
always important to standardize returns on a risk-adjusted basis so investors understand that
portfolio managers who follow a risky strategy are not more talented in any fundamental sense
than low-risk managers – they are just following a different strategy.
Another important consideration regarding these metrics is that they can only be compared to
one another directly. In other words, the Sortino ratio of one portfolio manager can only be
compared to the Sortino ratio of another manager. The Sortino ratio of one manager cannot be
compared to the information ratio of another. Fortunately, these five metrics can all be
interpreted in the same manner: The higher the ratio, the greater the risk-adjusted performance.
