More Bang For Your Buck: Comparing Risk-Adjusted Returns

by Catherina Pareto
MFI Correspondent

Investors are risk averse. So, if they are going to assume risk, they want the most bang for the buck, or the most return per unit of risk that they assume. With the help of a nifty formula called the Sharpe Ratio, named after its creator, Nobel Laureate and Stanford Economics Professor William Sharpe, investors can measure how effectively a fund utilizes risk, and compare funds with different risk profiles.

The Sharpe Ratio measures a fund's returns in excess of the risk free rate (usually 90 day Tbills) for a given period (usually 36 months) and divides it by the standard deviation (a statistical measure of risk) of those returns in the given period.  The higher a fund's Sharpe Ratio, the better the fund's historical risk-adjusted performance.  A high number means you get more return per unit of risk.

There is no benchmark for Sharpe ratio values.  And standing alone, the ratio does not mean much.  In order to be useful, the numbers should be compared with the Sharpe ratio of other funds.  For instance, if we compare a balanced fund with a pure growth fund, the Sharpe ratio will produce a risk adjusted measurement that not penalize the balanced fund for holding some bonds.

While the Sharpe ratio is a great tool for measuring risk, it's not perfect.  For instance, if a particular asset class is on a roll and does not experience a great deal of volatility, return per unit of risk does not necessarily reflect management genius.  A good example of this is tech fund behavior in 1999: momentum drove returns straight up, and Sharpe ratios higher. But, tech funds didn't experience the brunt of its sector's volatility until recently.

Despite its wide acceptance among academics and institutions, the Sharpe ratio is not well known among the general investing public. Modigliani and Modigliani (M&M) introduced a similar measure of risk in 1997. Since their measure is expressed in percentage points, M&M believe that average investors can more easily understand it. 

The Modigliani measure states the fund's performance as it relates to the market.  This measure equals the return the fund would have received if it had the same risk the market index had.  Like the Sharpe ratio, the higher the number the better.   Since this measure is relatively new, it's still early to tell if investors will embrace this concept with more understanding.

Mutual fund Sharpe ratios are published by some of the leading services like Morningstar, Value Line, Lipper, and Standard & Poor's.

The decision to buy a fund should never be based on numbers alone.  Among others, asset class representation, portfolio correlations, expenses, turnover, and style drift should always be considered when selecting a mutual fund.  But, the Sharpe Ratio or Modigliani measure provide valuable information on management effectiveness.

Catherina Pareto is the Marketing Director of Managed Account Services, Inc., a fee-only registered investment advisor with over $80million in assets. Cathy has a BBA in Finance from Florida International University and is a candidate for the CFA designation. She can be reached via email at Cathy@fee-only-advisor.com. 

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