Understanding risk-adjusted returns

How do you know whether you are compensated enough for the risk taken? Read my article to find out ...

http://epaper.gujaratimidday.com//epaperpdf/gmd/08022016/08022016-md-gm-12.pdf

The English translation is as under:

Risk-adjusted returns

Last time, we saw standard deviation and beta as measures of risk to compare two or more equity funds. These parameters measure the risk of volatility involved in the equity funds. This volatility could be on account of various factors. However, in most cases, the fund managers take the risk of volatility with an objective to generate high long term returns.

In such a case, it may not be proper to look at returns or risk in isolation. It would be prudent to see if the risk has been duly rewarded or not. Did the fund manager succeed in generating high returns for taking on higher risk?

Investment managers evaluate this question through what is known as “risk-adjusted return”. There are various ways to measure this parameter. The most popular among these is known as “Sharpe ratio”, named after Economist William Sharpe.

Assume there is an investor, who does not want to take any investment risk. Such an investor would have to be satisfied with “risk-free” rate of return. However, in order to earn higher than the “risk-free” rate, one will have to take some risk. Since we are discussing equity funds (a well-diversified equity portfolio) here, the only risk to consider is volatility. Now, by investing in equity fund, the fund manager has taken the risk of price volatility or fluctuations. Is he able to get returns higher than the risk-free rate? If yes, how much? This is what Sharpe ratio captures.

The equation for calculation of Sharpe ratio is as under:

Sharpe ratio = (portfolio return – risk-free rate) / standard deviation of the fund

Higher Sharpe ratio is considered to be better than a lower ratio, as the fund manager rewarded the investors for the risks taken.

As can be seen from the above equation, the excess return generated by the fund is in the numerator, whereas the standard deviation (as we saw last time, standard deviation is a measure of volatility – higher SD means higher risk) is in the denominator.

Higher standard deviation would reduce the Sharpe ratio. So, if the fund manager who takes higher risks gets a lower score. Similarly, higher returns would increase the Sharpe ratio. Thus, someone who can generate higher returns by taking lower risk would have a better Sharpe score compared to others. However, someone generating higher returns by taking high risk might get a similar score as someone who generates lower returns by avoiding risks.

Let us also understand that the numerator is excess return over risk-free rate and not just the return generated by the fund. Even if the fund has generated positive but less than risk-free return, the Sharpe ratio would be negative. This also means that the fund manager could not even generate risk-free returns in spite of taking the risk. Due to this, Sharpe ratio is not always the best indicator since when the overall market is down, most equity funds would also deliver negative or low returns. In such a case, the Sharpe ratio would be negative. Please do not judge this as incompetence of the fund manager. It would be prudent to compare two similar funds on this scale rather than looking at the Sharpe ratio of one fund and arriving at a conclusion.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.