The T. Rowe Price Health Sciences Fund (“PRHSX”) provides equity exposure to the health care, medicine and life sciences industries. Fund management is authorized to invest in companies of any market capitalization, with allocation based on fundamental research and valuation. To assess the suitability of the fund, investors should analyze its risk metrics including beta, standard deviation, capture ratios and risk-adjusted returns. The fund has a similar risk profile to the benchmark Morningstar U.S. Healthcare Index Total Returns while driving superior returns, though systematic risk has risen significantly.
Standard deviation measures the level of variance in a portfolio's monthly returns. High standard deviation indicates more volatility, and more volatile holdings are generally regarded as riskier investments requiring higher returns to offset additional risk assumed. The fund had a standard deviation of 17.2 percentage points over the three years ended March 2016, with a 16.4 percentage point standard deviation over five years and a 17.1 percentage point standard deviation over 10 years. The benchmark exhibited corresponding values of 17.6 percentage points, 16 percentage points and 17.1 percentage points. These values are higher than those of most bond or total equity market indexes, but the standard deviation metric indicates no additional risk from volatility for the fund above its sector benchmark.
Beta is a volatility statistic used in modern portfolio theory (MPT), and it measures the extent to which benchmark fluctuations influence returns. Beta values above 1 indicate higher volatility than the benchmark index and suggest higher systematic risk than a simple index tracking fund. The fund had a beta of 1.21 for the three years ended June 2016, with values of 0.82 over five years and 0.76 over 10 years. These different time frames offer varying evidence, but it seems that the fund has become more volatile than its benchmark in recent years. This would suggest rising systematic risk relative to the U.S. health care equity market.
R-squared measures the correlation between fund returns and benchmark performance, with values approaching 100% indicating that fluctuations in fund value can be explained more completely by changes to the benchmark index. The fund had a three-year R-squared value of 86% as of June 2016, with a five-year value of 46% and a 10-year value of 57%. This indicates high correlation over the preceding three years, with significantly lower correlation going further back in time. Low R-squared also reduces the explanatory value of beta, so the higher three-year beta coefficient is more meaningful than the lower values for the five- and 10-year periods.
Upside Downside Capture Ratios
Capture ratios measure the extent to which monthly fund returns track benchmark performance in bull and bear markets. The upside capture ratio is only calculated in months during which benchmark returns were positive, while the downside ratio only represents months in which losses are sustained. The fund had a three-year upside capture ratio of 106.1% as of March 2016, with a five-year ratio of 116.4% and a 10-year value of 96.2%. The corresponding downside ratios were 17.4, 34 and 48%. The fund has generally achieved similar performances to the benchmark during strong market conditions, even outperforming the market in recent years. With exceptionally low downside capture ratios, the fund has provided substantial insulation from deteriorating market conditions.
Alpha and Sharpe Ratio
Alpha and the Sharpe ratio are risk-adjusted return metrics. Alpha is an important element of MPT that measures returns in excess of the expected values based on beta and benchmark performance. Investment strategies that add value to the benchmark index have positive alpha, with higher values indicating superior performance. The fund's alpha was 0.18 over the three years ended June 2016, 15 over five years and 11.76 over 10 years. The fund has consistently outperformed expected value, but the outperformance has declined in recent years as correlation to the benchmark increased. The Sharpe ratio is calculated by dividing returns by standard deviation and analyzed by comparison to corresponding benchmark values. The fund's Sharpe ratio was 1.16 over the three years ended June 2016, 1.24 over five years and 0.9 over 10 years. The corresponding benchmark ratios were 0.5, 0.43 and 0.26. In all periods, the fund's returns were substantially higher than the benchmark after adjusting for volatility.