Risk Adjusted Returns refer to the measurement of risk involved in comparison to the returns of an investment or the amount of risk involved in producing the returns. It is usually expressed in numbers or ratings and applies to mutual funds, individual securities and portfolios. Risk adjusted returns help in analysing both high risk and low risk investments.
Risk measures include Sharpe ratio, Treynor Ratio, Alpha, Beta and others, which are different kinds of formulae applied to calculate the financial, operational, credit and market risks. Then it is used to analyse the returns and adjust risks. This technique helps the investors in taking a sound decision.
How does Risk Adjusted Returns Technique Help
This technique helps the investors in making a sound decision on which funds to invest in. Risk adjusted returns have an impact on portfolios. Funds with lower risk but high returns have better risk adjusted returns than a fund with high risk and high returns. Sometimes, funds with lower risk than benchmark may limit the returns whereas high risk-return funds may outperform in favourable market conditions in spite of suffering losses in volatile markets.
How to Calculate?
Among many measurement techniques, two of these have been quite popular as discussed below:
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Sharpe Ratio
Sharpe Ratio is the calculation of an excess return generated by the fund above the Risk Free Rate per unit Standard Deviation.
Sharpe Ratio = {Fund’s Return – Risk Free Rate} / Standard Deviation
Here, Risk Free Rate is the hypothetical rate of return with no risk. Theoretically, it is assumed to be the minimum rate of returns that an investor will get as s/he will not bear higher risks if there’s no potential of higher returns. It is the yield on a no risk investment such as Treasury Bond. Standard Deviation is the deviation of the performance of a fund from its past records. It is the deviation from expected returns as per the records. A higher Sharpe Ratio is better, as it means better risk return adjustment. For example, if there are two fund schemes, A & B with respective returns of 12% & 15% and the Free Risk Rate for the particular period of time was 2%. Standard deviation is of 7% & 10% for Mutual Funds A and B respectively. Now Sharpe Ratio of each is:
Mutual Fund A Sharpe Ratio = {12% – 2%} / 7% = 1.42
Mutual Fund B Sharpe Ratio = {15% – 2%} / 10% = 1.30
So, even if the returns were higher for Fund B , the Sharpe Ratio was slightly higher for A which means the latter had better risk adjusted returns.
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Treynor Ratio
Calculated in the similar fashion as Sharpe ratio, the only difference is of the denominator here. Treynor Ratio is the difference between returns of the investment and free risk rate divided by the investment’s Beta. Beta or Beta Coefficient is the measure of the volatility of the fund or the systematic risk of any security or portfolio with respect to the market as a whole. For instance, if the two mutual fund plans as mentioned above, A & B with returns of 12% and 15% have Beta as 0.5 each and the Free Risk Rate is 2%. Then the Treynor Ratio will be as:
Mutual Fund A Treynor Ratio = {12% – 2%} / 0.5 = 0.20
Mutual Fund B Treynor Ratio = {15% – 2%} / 0.5 = 0.26
Here, we see that as per Treynor Ratio, Mutual Fund B offers better risk adjustment i.e. it is earning higher returns per unit of systematic risk.
Limitations
Sharpe Ratio and Treynor Ratio along with other measures help in analysing the risks of the fund scheme and help in optimization of the returns. However, they are just numbers and do not give any insight into what sectors or companies of what size/capitalization the fund is invested. It is not accountable for portfolio risk whether it is diversified or not. The fund scheme may have a high Sharpe/Treynor Ratio but could be a Sectoral Fund with more concentration on one industry.