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Understanding risk-adjusted returns

In the industry, we are accustomed to reading primarily how investments have fared in terms of total returns. Because let’s face it, in essence, that it was matters most to investors right? It’s the percentage points that really matter most to an investor and if Asset A performed better than Asset B over an equal time horizon, then Asset A is considered to be a better asset. It goes without saying right?

Well, not quite. Investment Managers, Portfolio Managers, Risk Managers and Financial Advisors pay a great deal of importance to risk-adjusted returns in their day to day decision making and factor this concept in their decision making process.

This concept is not easily understood by retail investors, but is one which should be given its due importance in order to get a glimpse of the risk being allocated to an individual investment as well as to monitor how the investment, instrument, asset is behaving over time given the historical pattern of returns.

The concept of risk-adjusted returns, which by definition measures the amount of risk involved in an investment’s return, is of paramount importance as it enables investors to carry out a comparative analysis on a like for like basis, between the performances of a risk investment with that of a less risky investment and hence with varying levels of return.

Risk adjusted return can apply to equities, bonds, portfolio as well as to investment funds. In essence, it is a unit of measurement which places different assets on equal footing to help determine the efficacy of returns per unit of risk undertaken.

There are 5 key methods of assessing the relative performance of different types of assets by portfolio managers, namely Alpha, Sharpe Ratio, r-squared, beta and standard deviation.

All methods are valid and have unique distinct features, each having their pros and cons, depending on the need for the calculation of the metrics as well as on the type of asset class the computation is being performed.

The inputs for each method varies from market rate of return, to asset class performance and risk free rate of return, which gives investors and portfolio managers the freedom and flexibility to use the calculation of choice. However, it is important to note that for comparative purposes, the same methodology must be applied when measuring and comparing risk adjusted return on two assets.

The Sharpe ratio is the most commonly used form of calculating and measuring risk adjusted returns. Through the calculation, an investor can compute the target expected rate of return by the potential impact of volatility of returns as well as the total amount earner per 1 given unit of risk.

As the Sharpe Ratio of an asset increases, the investor is better off holding that asset since it means that the historical adjusted return is superior since it indicates a higher unit of return for a given unit of risk.

The Sharpe ratio formula for a portfolio is calculated as follows:

(Portfolio return – Risk free return) / Standard deviation of portfolio return

The tolerance of risk varies between one investor and another, as each investor has his/her own distinct risk profile and has his/her own appreciation of risk. It also depends on an investor’s financial profile such as overall wealth position, cash flow, and behavioural traits during times of market volatility, etc. Investors can improve risk adjusted returns by adjusting their asset allocation accordingly depending on market volatility and market outlook.

Differing strategies and financial models exist on how to optimise risk adjusted returns and how to best take advantage of market opportunities in order to maximise total returns for every increase in unit of risk undertaken. It is important however to note that each calculation methodology has its limitations but nevertheless, the concept of risk adjusted returns is one of the most critical building blocks in understanding financial markets in greater detail.

 

This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. 

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