Imagine there was Fund A, which returned 5% per annum, and Fund B, which returned 4% over the same period. Would you say that Fund A was a superior investment? Well, you might say that, if the returns were all you had to go by.
But what if I told you that Fund A was a mutual fund that invested in a basket of stocks, and Fund B was the CPF Special Account?
Well, in that case, you’ll probably realise that Fund B was superior, since it generated 4% returns at virtually no risk, while Fund A probably underperformed compared to its peers that undertook similar risk. The nominal return of 1% over Fund B was probably mediocre, considering the much higher risk your portfolio was subjected to.
Risk-adjusted returns is an important concept to take into account when evaluating the performance of a particular asset class or fund, which will help you make better investment decisions.
What Does Risk-Adjusted Returns Mean?
Risk-adjusted returns measure an investment’s return, relative to the amount of risk the investment has been exposed to.
Common ways to measure risk include the Sharpe Ratio, beta, and R-squared. Since each of these risk measures use a different methodology to quantify risk, investors should take care to only measure the risk-adjusted returns two investments using the same risk measure.
Measuring Risk-Adjusted Returns Using The Sharpe Ratio
The Sharpe ratio is a measure of an investment’s returns above the risk-free rate, for each unit of standard deviation. In simple terms:
(Investment Returns – Risk Free Rate) / Standard Deviation of Investment
All else being equal, the higher the Sharpe ratio, the better.
What constitutes “risk-free rate” of investment returns can differ, but treasury bills issued by the central bank (in our case, MAS) are usually taken as a reference. For those who are not familiar with standard deviation, it measures the volatility of an investment’s returns relative to the average return.
As an example, we have Fund C and Fund D, which both yielded an impressive 10% per annum. The latest round of t-bills released by MAS on 31 July 2018 gives an average yield of 1.59% per annum, and let’s say the standard deviation for funds C and D was 5% and 15%, respectively. Let’s see which fund gave better risk-adjusted returns.
Fund C Sharpe Ratio = (10% – 1.59%) / 5% = 1.682
Fund D Sharpe Ratio = (10% – 1.59%) / 10% = 0.841
As you can see, even though both investments yielded the same returns, one of them can be said to have underperformed, for the risk that it took.
Temasek Uses Risk-Adjusted Returns To Measure Performance
Temasek Holdings adopts a comprehensive risk-adjusted methodology that takes into account the inherent risks and expected to measure their own performance. For each investment type, it sets for itself “hurdles” (internal benchmarks) and measures success by how much more value can they add above and beyond the typical risk-adjusted return.
Past Results Do Not (Really) Matter
There is a problem of basing your investment methodology just based on backtested data. After all, if my ‘investment strategy’ during the recent World Cup was to invest everything I had into France, it would look like that was a great strategy that yielded fantastic returns. But if I were to understand that the risk I was taking, relative to the returns, then it might not look so mouthwatering.
Is it a good strategy to ‘invest’ all your money in France at the next World Cup? Obviously not, since like the stock market, past performance is no indication of future results, but what is certain is the risks that each investment carries.
So the next time a financial adviser cherry picks unit trusts and show you how well it performed, look deeper and understand how much risk that fund took, and if you look further, you’ll probably see the corpses of many other unit trusts in the stable who weren’t as ‘lucky’.
If you’re interested to learn more about risk management, check out this video we produced: