Alpha, beta, Sharpe ratio: these metrics are ubiquitous tools in the investment community. When used correctly, they can help investors better evaluate their decisions. User incorrectly, they may lead to erroneous conclusions.
Effectively evaluating an investment goes beyond observing short-term absolute returns. As a Financial Advisor, I can choose from hundreds of funds to help my clients reach their investment and financial goals. I use numerous measures to help decipher the full implications of various investment choices by examining the factors in this four-part blog series: measuring returns, risk, risk-adjusted returns and benchmarks.
In Part Three, I explain in more detail how I look at risk-adjusted returns.
As in the first two parts of this 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.
Risk-Adjusted Returns Case Study Summary
In this case, Manager A was more successful in outperforming on a risk-adjusted basis, measured by a positive alpha and higher Sharpe ratio.
In the next post in this series, I’ll explain and discuss how financial advisors use benchmarks in more detail.
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