Evaluating Risk: Measuring Returns

At Principled Solutions, most of our portfolios are made up of various mutual funds or exchange-traded funds. There are hundreds of funds available for any given asset class and objective.  How do we select which funds to use? One way is to compare fund results on an array of metrics. In this blog series, I’ll explain more about how I help my clients reach their goals by using specific metrics, including measuring returns, risk, risk-adjusted returns, and benchmarks.

The Hypotheticals

To illustrate each metric in this blog series, consider this hypothetical case study:

  • Two hypothetical managers, Manager A and Manager B, have similar investment styles and measure their performance against the same hypothetical benchmark.
  • The risk-free rate of return is 3%
  • The most recent annual returns for each manager and the benchmark are listed below.

In the hypothetical above, all returns are provided gross of fees; investment management fees would otherwise reduce performance that an investor would experience.

Case Study Summary

The metrics provide some valuable insight when evaluating both managers:

  • Although Manager B produced a greater arithmetic return, Manager A produced the greater geometric (compounded) return.
  • Both managers provided positive excess return above the benchmark.
  • Manager A was more consistent (less risky) than Manager B and the benchmark, as evidenced by the lower standard deviation and beta.
  • Manager A was more defensive (lower downside capture ratio), while Manager B was more aggressive (higher upside capture ratio).
  • Manager A was more successful in outperforming on a risk-adjusted basis, measured by a positive alpha and higher Sharpe ratio.
  • Manager A provides a greater probability of continuing to outperform the benchmark, given the higher information ratio.

Of course, it’s important to note other qualitative factors, such as an investor’s investment objectives and a manager’s investment technique and philosophy, should be taken into consideration during the selection and evaluation process.

In the next post in this series, I’ll explain and discuss how financial advisors measure risk in more detail.

 

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