The overall performance of your portfolio is the ultimate measure of success for your portfolio manager. However, total return cannot exclusively be used as the correct benchmark when determining whether or not your designated money manager is doing his/her job effectively.
For example, a 2% annual total portfolio return may initially seem small. However, if the market only increased by 1% during the same time interval, then the portfolio performed well compared to the universe of available securities. On the other hand, if this portfolio was exclusively focused on extremely risky microcap stocks, the 1% additional return over the market does not properly compensate the investor for risk exposure. Based on the need to accurately measure performance, various ratios are used to determine the riskadjusted return of an investment portfolio. We'll look at the five common ones in this article.
Sharpe Ratio
The Sharpe ratio, also known as the rewardtovariability ratio, is perhaps the most common portfolio management metric. The excess return of the portfolio over the riskfree rate is standardized by the standard deviation of the excess of the portfolio return. Hypothetically, investors should always be able to invest in government bonds and obtain the riskfree rate of return. The Sharpe ratio determines the expected realized return over that minimum. Within the riskreward framework of portfolio theory, higher risk investment should produce high returns. As a result, a high Sharpe ratio indicates superior risk adjusted performance.
Many of the following ratios are similar to the Sharpe in that a measure of return over a benchmark is standardized for the inherent risk of the portfolio, but each has a slightly different flavor that investors may find useful, depending on their situation.
Roy's SafetyFirst Ratio
Roy's safetyfirst ratio is similar to the Sharpe, but introduces one subtle modification. Rather than comparing portfolio returns to the riskfree rate, the portfolio's performance is compared to a target return.
The investor will often specify the target return based on financial requirements to maintain a certain standard of living, or the target return can be another benchmark. In the former case, an investor may need $50,000 per year for spending purposes; the target return on a $1 million portfolio would then be 5%. In the latter scenario, the target return may be anything from the S&P 500 to annual gold performance – the investor would have to identify this target in the investment policy statement.
Roy's safetyfirst ratio is based on the safetyfirst rule, which states that a minimum portfolio return is required, and that the portfolio manager must do everything he can in order to ensure this requirement is met.
Sortino Ratio
The Sortino ratio looks similar to the Roy's safetyfirst ratio  the difference being that, rather than standardizing the excess return over the standard deviation, only the downside volatility is used for the calculation. The previous two ratios penalize upward and downward variation; a portfolio that produced annual returns of +15%, +80% and +10%, would be perceived as fairly risky, so the Sharpe and Roy's safetyfirst ratio would be adjusted downward.
The Sortino ratio, on the other hand, only includes the downside deviation. This means only the volatility that produces fluctuating returns below a specified benchmark is taken into consideration. Basically, only the left side of a normal distribution curve is considered as a risk indicator, so the volatility of excess positive returns are not penalized. That is, the portfolio manager's score isn't hurt by returning more than was expected.
Treynor Ratio
The Treynor ratio also calculates the additional portfolio return over the riskfree rate. However, beta is used as the risk measure to standardize performance instead of standard deviation. Thus, the Treynor ratio produces a result that reflects the amount of excess returns attained by a strategy per unit of systematic risk. After Jack L. Treynor initially introduced this portfolio metric, it quickly lost some of its luster to the now more popular Sharpe ratio. However, Treynor will definitely not be forgotten. He studied under Italian economist Franco Modigliani and was one of the original researchers whose work paved the way for the capital asset pricing model.
Because the Treynor ratio bases portfolio returns on market risk, rather than portfolio specific risk, it is usually combined with other ratios to give a more complete measure of performance.
Information Ratio
The information ratio is slightly more complicated than the aforementioned metrics, yet it provides a greater understanding of the portfolio manager's stockpicking abilities. In contrast to passive investment management, active management requires regular trading to outperform the benchmark. While the manager may only invest in S&P 500 companies, he may attempt to take advantage of temporary security mispricing opportunities. The return above the benchmark is referred to as the active return, which serves as the numerator in the above formula.
In contrast to the Sharpe, Sortino and Roy's safetyfirst ratios, the information ratio uses the standard deviation of active returns as a measure of risk instead of the standard deviation of the portfolio. As the portfolio manager attempts to outperform the benchmark, she will sometimes exceed that performance and at other times fall short. The portfolio deviation from the benchmark is the risk metric used to standardize the active return.
The Bottom Line
The above ratios essentially perform the same task: They help investors calculate the excess return per unit of risk. Differences arise when the formulas are adjusted to account for different kinds of risk and return. Beta, for example, is significantly different from trackingerror risk. It is always important to standardize returns on a riskadjusted basis so that investors understand that portfolio managers who follow a risky strategy are not more talented in any fundamental sense than lowrisk managers, they are just following a different strategy.
Another important consideration regarding these metrics is that they can only be compared to one another directly. In other words, the Sortino ratio of one portfolio manager can only be compared to the Sortino ratio of another manager. The Sortino ratio of one manager cannot be compared to the information ratio of another. Fortunately, these five metrics can all be interpreted in the same manner: The higher the ratio, the greater the risk adjusted performance.

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