Sharpe Ratio: How you can measure risk-adjusted return when things are looking scary
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Weakness in global equity markets throughout 2022 has provided a good reminder of why an understanding of risk-adjusted return and its key measure the Sharpe ratio is so important.
Welcome to Sharpe ratio 101 with our guest lecturer today VanEck Australia Portfolio Manager Cameron McCormack. Firstly, we need to understand exactly what is risk-adjusted return.
“Risk-adjusted return is a way of measuring the performance of an investment that factors in risk; that is, the extra risk required to get higher returns,” said McCormack.
A little historical context is also good. In 1966 American economist William F Sharpe developed the Sharpe ratio, also known as the Sharpe index, the Sharpe measure, and the reward-to-variability ratio as an investment performance analysis tool.
McCormack said the Sharpe ratio is a way to measure the risk-adjusted returns of investments calculated by comparing an investment’s return to that of a risk-free asset, such as cash.
The Sharpe ratio is one of the most widely used methods for measuring risk-adjusted relative returns.
“Part of the ratio’s popularity is based on the simplicity of calculating and interpreting the ratio,” McCormack said.
“It compares historical or projected returns relative to an investment that carries no risk, or risk-free rate, with the historical or expected variability of such returns.
“The risk-free rate used is usually government bonds, because, hypothetically, these carry zero risk.”
Many investment funds routinely publish the Sharpe ratio as part of quarterly and annual performance updates which are circulated to clients.
“The Sharpe ratio can be used to evaluate a single security or an entire investment portfolio, with the higher the ratio, the better the investment in terms of risk-adjusted returns,” McCormack said.
“The Sharpe ratio helps you determine whether the risk you’ve taken on has paid off in your returns, compared to the returns you may have had without taking on the risk.”
The Sharpe ratio is calculated by determining an asset’s excess return above the risk-free rate for a given time.
“This amount is divided by the portfolio’s standard deviation, which is a measure of its volatility,” he said.
“The ratio works by giving investors a score that tells them their risk-adjusted returns.”
McCormack said it can be used to analyse past performance or anticipated future performance.
“The ratio can be used by investors as a way of understanding whether returns are due to smart decisions or just taking on higher levels of risk,” he said.
“If returns are due to an investor taking on higher levels of risk the investor may lose more money than they are comfortable with when conditions change.”
Time for some maths.
Sharpe Ratio = (Rp-Rf) / Standard deviation
Rp is the expected return.
Rf is the risk-free rate.
McCormack said standard deviation is a statistical measure of dispersion and is used to assess the risk of an asset.
“By analysing price movements of an asset over a period of time, relative to the mean of these price movements, the standard deviation represents the variance of these price movements,” he said.
“The higher the standard deviation, the larger variations you can expect to see in returns.
“A higher standard deviation of returns indicates higher risk.”
McCormack uses the example of considering two portfolios. Portfolio 1 is expected to return more than 15% over the next 12 months, while portfolio 2 is expected to deliver a return of 12% over the same period.
“Without considering risk, Portfolio 1 is clearly the superior choice based on returns alone,” he said.
However, in this example, Portfolio 1 has a standard deviation of 8% (higher risk) and Portfolio 2 has a standard deviation of 4% (lower risk).
The risk-free rate is 3.5%, based on the one-month US treasury bill.
Portfolio 1: (15-3.5)/8 = Sharpe ratio of 1.44
Portfolio 2: (12-3.5)/4 = Sharpe ratio of 2.13
“So, in this case, Portfolio 2 has a better risk-adjusted return,” McCormack said.
McCormack said when observing Sharpe ratios, it’s important to understand the drivers of returns and volatility of each asset class or sector during the time assessed.
Between the Global Financial Crisis and Covid-19, the world was in a low-inflation, low-growth economic environment.
“During this period companies that exhibited the quality factor did extremely well,” McCormack said.
However, now we’re in a persistent high-inflation environment.
“Sectors that performed well pre-Covid like Information Technology are now out of favour while inflation-linked sectors such as energy have been best performers,” he said.
“Sharpe ratios are a powerful tool but should be looked at alongside metrics such as drawdowns, alpha and tracking error when forming investment decisions.
“Past performance is not indicative of future results.”
To learn more about investing in during periods of heightened volatility check out Stockhead Eddy Sunarto’s article on Options trading.