Risk Adjusted Return Measures
There are a number of techniques used to measure investment returns after adjusting for risk.
The Sharpe Ratio
This ratio has become the industry standard for risk-adjusted return. It is calculated as the standard deviation of portfolio returns (denominator) divided into the difference between the mean portfolio return and the risk free rate (numerator).
Measuring the mean excess return per unit of volatility, the Sharpe ratio can be inaccurate if applied to portfolios that have nonlinear risk exposures (such as those related to option contracts.)
The Sortino Ratio
The concept of the Sortino ratio is that managers should not be punished for excess positive volatility. Instead, it relies on MAR – the minimum acceptable return for the portfolio.
The numerator of the Sortino ratio is the difference between the mean portfolio return and the MAR. The denominator is the downside deviation (volatility of points below) the MAR.
If the risk-free rate is assumed to be the MAR, the only difference between the Sharpe and Sortino ratios is the use of downside deviation in the denominator. If used in conjunction with the Sharpe ratio, the Sortino can illustrate the risk-adjusted performance specific to outlying positive results.
Risk Adjusted Return on Capital
Divides expected return by capital at risk, which can be defined in a variety of ways. Some companies allocate capital using a hurdle rate for risk-adjusted return on capital.
Return Over Maximum Drawdown
Drawdown is the difference between any given high-water mark for a portfolio and the subsequent low point. Maximum drawdown is the largest such difference in the portfolio’s history.
Return over maximum drawdown expresses the average return as a percentage of the maximum drawdown. It allows investors to ask whether they are willing to accept a given average return in exchange for a given possible occasional drawdown rate.
For more information, see all articles on: Active Management, Institutional Investing, Investment Returns, Portfolio Management, Risk Management See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
[...] Sharpe ratio is often used for evaluating hedge fund performance. However, it has often been criticized for [...]
April 19th, 2008 at 12:37 pm