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Investors have one goal when they invest: to generate money. And every single investor wants to make as much money as possible. Investors usually calculate the performance of a fund-based portfolio on the best returns. Internal rate of return or IRR in short is a frequently used measure that estimates the profitability of one’s investments. Its popularity comes from its nature of simplicity in terms of understanding and calculating, however portfolios are not all the same if so, there wouldn’t be a need for segregation and grouping into similarities based on categories or mandates. The ease of use of the ratio may be appealing but investment after thorough due diligence will help investors understand how returns are being generated and more importantly what is the risk that is being taken, to avoid blaming one’s degree of luck when things turn sideways.
In this blog, we aim to educate and provide you with the tools required in understanding the return being generated for the risk one assumes.
Investors, however tempting it may be to invest in funds based on the highest recent returns showcased, comparing the portfolio’s performance based on risk-adjusted returns gives you a better picture.
The reason is that the absolute measurement of return does not consider the mean or the variability of returns. Investment based solely on this might expose one’s investment to frequent fluctuations and can be mentally exhaustive if one tracks the portfolio every day. Investors need a standardized way of measuring returns expected for the assumed level of risk to make investment decisions.
If two investments provide the same returns over some time, the low-risk investment will have a better risk- adjusted return. Another way of understanding this is that if a fund/scheme has a lower risk-adjusted return but higher absolute returns, then it means that it is taking riskier bets in pursuit of higher returns. Sometimes these bets pay off and other times these do not.
An example of this would be including a lot of stocks that are small and mid-caps in your portfolio. While they might provide higher returns, in the long run, they also suffer from higher volatility. From the investor’s point of view, an ideal scheme would be one that would provide the highest returns with risk they can tolerate.
There are numerous metrics to calculate risk-adjusted returns, but we will focus on a few that are common amongst analysts. But before we do, we need to understand some basic terminologies.
Beta – Measures the volatility of the stock in comparison to the market. Market Beta is 1 which represents a standard, a stock Beta higher than 1 indicates more volatility in the investment as compared to the market and vice versa.
Standard Deviation – Measures deviation of the dataset from its mean. A volatile stock has a higher Standard Deviation and vice versa. To put it simply it tells how much an asset’s return varies over the observed period compared to its mean return.
Now that we have understood the two basic terminologies used, we will go ahead with how to calculate risk- adjusted returns.
Sharpe Ratio – It measures the excess return of an investment per unit of volatility using standard deviation, a statistical measure of variance. It is calculated by subtracting the risk-free return (i.e the returns generated by a risk-free asset like a government bond) from the portfolio return; this is also known as an excess return. Subsequently, this excess return is divided by the portfolio return’s standard deviation. This ratio is used to calculate the excess return on an additional unit of risk taken. It is measured monthly and then annualized.
Formula: Sharpe ratio = (Average fund returns-Risk free rate) / Standard Deviation of fund returns Let’s say, The Sharpe ratio of a fund is 1.5 per annum then the portfolio generates 1.5% extra return on every 1% of additional risk it takes. It is a measure of return with its volatility taken into consideration. A scheme with a higher Sharpe ratio implies that the fund generates a higher return for every unit of risk it takes.
Treynor Ratio – This calculation is similar to the Sharpe ratio; it also measures the excess portfolio returns for an additional unit of risk assumed. The difference here however is volatility is measured by the beta of the portfolio such a portfolio. The reason is a standard deviation to has limits for example, standard deviation considers favourable uncertainty that is stock price moving up as volatility as well.
Formula: Treynor ratio = (Portfolio’s Return- Risk free return rate)/Beta of the portfolio
Right Horizons with over two decades of experience in the financial markets uses a proprietary risk assessment and investment philosophy to provide superior risk-adjusted returns across its various schemes.
Exhibit 1:
