The overall performance of your portfolio is the ultimate measure of success for your portfolio manager. However, total return cannot exclusively be used when determining whether or not your money manager is doing his or 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 micro-cap stocks, the 1% additional return over the market does not properly compensate the investor for risk exposure. To accurately measure performance, various ratios are used to determine the risk-adjusted return of an investment portfolio. We'll look at the five common ones in this article.
The Sharpe ratio, also known as the reward-to-variability ratio, is perhaps the most common portfolio management metric. The excess return of the portfolio over the risk-free 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 risk-free rate of return. The Sharpe ratio determines the expected realized return over that minimum. Within the risk-reward framework of portfolio theory, higher risk investments should produce high returns. As a result, a high Sharpe ratio indicates superior risk-adjusted performance.
For more, see: Understanding the Sharpe Ratio.
Many of the ratios that follow 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 Safety-First Ratio
Roy's safety-first ratio is similar to the Sharpe but introduces one subtle modification. Rather than comparing portfolio returns to the risk-free 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 safety-first ratio is based on the safety-first rule, which states that a minimum portfolio return is required, and that the portfolio manager must do everything he or she can in order to ensure this requirement is met.
The Sortino ratio looks similar to the Roy's safety-first 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 safety-first 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.
The Treynor ratio also calculates the additional portfolio return over the risk-free 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.
The information ratio is slightly more complicated than the aforementioned metrics, yet it provides a greater understanding of the portfolio manager's stock-picking 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. (For related reading, see Choose a Fund With a Winning Manager.)
In contrast to the Sharpe, Sortino and Roy's safety-first 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, he or 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 tracking-error risk. It is always important to standardize returns on a risk-adjusted basis so investors understand that portfolio managers who follow a risky strategy are not more talented in any fundamental sense than low-risk 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.