The overall performance of your portfolio is the ultimate measure of how well your portfolio manager does their job. The five performance ratios presented below provide investors with various measurement options.
Measuring total return isn’t the best way to determine whether or not your investments are being managed effectively. For a clearer picture, you must measure your portfolio’s risk-adjusted return.
Accounting for risk fine-tunes the concept of return. For example, a 2% annual total 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.
With that information, an investor could have a meaningful discussion of performance quality with their portfolio manager.
Key Takeaways
- Understanding the performance of your portfolio can help you size up the performance of your portfolio manager.
- For an effective measurement of your portfolio’s investment performance, determine your portfolio’s risk-adjusted return.
- The total return doesn’t provide the full picture of performance because risk isn’t accounted for.
- When comparing the performance of different investments, be sure to use the same ratio for each so that you compare apples to apples.
1. Sharpe Ratio
Portfolio Standard Deviation(Expected Return − Risk Free Rate)
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.
How It Works
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.
Some 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 approach that investors may find useful, depending on their situation.
2. Roy’s Safety-First Ratio
Portfolio Standard Deviation(Expected Return − Target Return)
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.
How It Works
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 they can in order to ensure this requirement is met.
An investor will often specify that their target return should be based on a certain benchmark, such as a particular financial amount that allows them to maintain a certain standard of living.
In such a case, an investor may need $50,000 per year for spending purposes; the target return on a $1 million portfolio would then be 5%.
If the benchmark is a specific index, the target return might be tied to the S&P 500. Or the investor might use the annual performance of gold as a target. The investor would have to identify their target in the investment policy statement.
3. Sortino Ratio
Downside Standard Deviation(Expected Return − Target Return)
The Sortino ratio looks similar to the Roy’s safety-first ratio. The difference is 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. For example, 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.
How It Works
The Sortino ratio, on the other hand, only includes the downside deviation. This means that 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 is not penalized. That is, the portfolio manager’s score isn’t hurt by returning more than was expected.
Note
A risk-adjusted return for a portfolio is a higher quality metric than total return because it incorporates the risks inherent in an investment. It provides a clearer view of your reward relative to the investment’s risks.
4. Treynor Ratio
Portfolio Beta(Expected Return − Risk Free Rate)
The Treynor ratio also calculates the additional portfolio return over the risk-free rate.
How It Works
In this case, beta is used as the risk measure to standardize performance instead of standard deviation. Thus, the Treynor ratio produces a result that reflects the number of excess returns attained by a strategy per unit of systematic risk.
Since the Treynor ratio bases portfolio returns on market risk, rather than on portfolio-specific risk, it is usually combined with other ratios to give a more complete measure of performance.
After Jack L. Treynor 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.
5. Information Ratio
Tracking Error(Portfolio Return − Benchmark Return)
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 a 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.
How It Works
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, they 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.
Potential Pitfall
Problems 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. So you must use the same ratio when comparing returns.
In other words, the results of the Sortino ratio relating to one portfolio manager must only be compared to the Sortino ratio for another.
What Is Risk-Adjusted Return?
It’s the return of an investment relative to its risk. It helps investors determine whether investing in a security is worth the risk involved.
What Is Total Return?
Total return is the income produced by your investment plus the growth in its value. It’s expressed as a percentage of the amount that you have invested.
What Is the Jensen Ratio?
The Jensen ratio, or Jensen’s Alpha, is another way to measure risk-adjusted return. In particular, it measures the excess return over expected return and adjusts for market risk.
The Bottom Line
The five ratios presented above can help investors to calculate excess return per unit of risk and size up portfolio performance. They all can be interpreted in the same manner: The higher the ratio, the greater the risk-adjusted-performance.
Standardized risk-adjusted returns allow investors to understand that portfolio managers who follow a risky strategy are not more talented in any fundamental sense than low-risk strategy managers. They are just following a different strategy.