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Risk-Adjusted Performance

Morningstar Analysts | 11-01-12 | E-mail Article


The ultimate goal for any individual to invest is simply to make more money. Regardless of how much money an investor wants to make, it is crucial to identify the right investments to achieve the target returns over a designated time horizon.

Many fund investors tend to base their investment decisions on how much a fund has returned in the past. While this may give investors an idea of the expected return from the fund in future, the performance numbers do not indicate how much the investor has to give or, more precisely, how much risks he or she has to assume in order to attain the level of returns. In general, the higher the return of a fund, the higher the risks associated. Ideally, investors would prefer to the fund with lower risk when two funds exhibit similarly attractive performance over the same period of time. Risk-adjusted performance measures are useful for investors to compare funds for their optimal choices. Statistically, alpha and Sharpe ratio are two commonly used tools that are both simple and easy to interpret.

Measuring the Excess Return of A Fund by Alpha
Alpha is generally referred to as the excess return achieved by a fund above its relevant benchmark. It is typically considered as a measure of the value added by the fund manager. In other words, alpha reflects how much of a fund's return can be attributed to the manager's skills. To obtain alpha, a fund's return volatility is compared with a benchmark which includes similar investments as its constituents. A fund with a positive alpha means the fund has delivered better returns than its benchmark, whereas a fund with a negative alpha means the fund's return has trailed its benchmark performance. Comparing the alphas of funds using the same benchmark allows us to discern the manager whom has added the greatest value in the particular scope of investment.However, alpha is meaningful only when a fund is compared with an appropriate benchmark. The appropriateness of the benchmark chosen is verified by the fund's R-squared. Essentially, the fund's R-squared has to be at least 80 to qualify its benchmark; and the higher the R-squared, the more meaningful the alpha.

Assessing Fund's Risk and Reward by Sharpe Ratio
There are times when a fund cannot find an appropriate benchmark; Value Partners A Fund which invests primarily in small companies having substantial business operations in China can hardly find an appropriate benchmark in the market because the market indexes constitute mostly of large- to mid-cap stocks or include stocks in either Hong Kong or China only. In such case, Sharpe ratio is the better alternative risk-adjusted measure for risk/reward comparison. The calculation of the Sharpe ratio does not require a reference benchmark, but bases solely on a fund's returns and its standard deviation. In essence, the higher the Sharpe ratio, the higher the risk-adjusted return of a fund. If a fund has high volatility in terms of a high standard deviation, it needs to have a high return to ensure a high Sharpe ratio. On the other hand, a fund with moderate return can also has a high Sharpe ratio, provided that its volatility is low.Sharpe ratio can be used to compare different types of funds, since its calculation is the same for all funds. Yet, Sharpe ratio is a relative measure and the information it conveys by itself is limited. We simply do not know if a Sharpe ratio of 2 is high or low unless we compare the value with those of the other funds. All we can tell is that the positive value implies the fund's returns have been high enough to compensate the risks it has taken.

Simple But Not All
Alpha and Sharpe ratio are no doubt simple statistics for investors to examine how well a fund has been doing in the past. However, these statistics can only be used as reference but offer no predictive power due to the historical data they use for calculation. In fact, the statistics only tell us part of the story, i.e. only the quantitative characteristics of the fund; they do not provide us any information qualitatively. For instance, if there has been a management change during the measuring period, we do not know if it was the old or new management team responsible for the risk-adjusted return attained. We must look closer back into the fund's history and check if the new management has done a better or worse job than its predecessor. Above all, where a portfolio may have a few funds with high risk-adjusted returns, it may still not be a good portfolio because the holdings may be over-concentrated in, say, a sector or a few stocks. Then the portfolio is subject to any changes in that particular sector or in those stocks for desirable risk-adjusted return.In short, investors should always take a portfolio approach to mix and match their fund investments for the optimal level of diversification possible to meet their goals. Don't simply base decisions on performance numbers.

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