Risk-adjusted performance: What it is and why it matters


Warren Buffett has pointed out that you only find out who is swimming naked when the tide goes out.

Indeed, the recent pullback in pricey growth stocks and momentum names has been tough on hedge funds that were caught wrong-footed after chasing hot performers.

The point is investors may want to look beyond just performance when evaluating portfolio managers. The reason is that sparkling returns could mask the fact that the manager is taking on huge risks to achieve the performance.

That’s why many financial advisers and sophisticated investors look at risk-adjusted performance.

  • Risk-adjusted returns: A catch-all phrase for portfolio metrics designed to reveal how much risk was taken to achieve a return, incorporating volatility, sensitivity to overall market moves, and other measures.

  • Volatility: Measures the tendency of a portfolio to fluctuate in price. Generally speaking, portfolios with higher volatility are viewed as riskier. Standard deviation is a popular volatility measure.

  • Sharpe Ratio: A common risk-adjusted performance metric developed by Nobel laureate William F. Sharpe. Specifically, Sharpe Ratio determines a portfolio’s return over and above the “risk free rate” — typically the 10-year Treasury bond — and divides that figure by the portfolio’s standard deviation. Portfolios with higher Sharpe Ratios are seen as having better risk-adjusted performance.

  • Sortino Ratio: A variant of the Sharpe Ratio that focuses more on downside volatility rather than overall volatility. A higher Sortino Ratio suggests the portfolio has had fewer large declines.

  • Value at risk: Designed to quantify the maximum that a portfolio could lose in a given time period.

  • Information Ratio: Another variation of the Sharpe Ratio designed to evaluate the skill of active managers. It measures the amount of excess return generated from excess risk relative to an index such as the S&P 500. Managers with high information ratios are seen as more likely to generate consistent outperformance against the benchmark.

  • Alpha: Also known as excess return, alpha compares the volatility and performance of a portfolio against a benchmark. Investors use alpha to estimate the value that a portfolio manager adds compared to simply tracking an index. Investors desiring outperforming managers often look for portfolios with higher alpha.

  • Beta: A measure of a portfolio’s sensitivity to the overall market, typically the S&P 500. The market has a beta of 1. So if a portfolio has a beta of 1.15 for example, it has outperformed the market by 15% when the market is rising, and trailed the market by 15% in down markets. In other words, the portfolio is 15% more volatile than the index. Portfolios with a beta below 1 are less volatile than the market.

  • R-Squared: A correlation measure based on the relationship of a portfolio to its benchmark, expressed as a percentage between 1 and 100. A portfolio with an R-squared of 100 means all of its movements can be explained by fluctuations in the index.

On Covestor, investors can check every portfolio’s volatility, worst 30-day performance, Sharpe ratio, Sortino ratio, maximum drawdown, and value-at-risk.

As an example, here is a snapshot of a portfolio risk metrics page from our website:

Additionally, our Investment Management team assigns a Risk Score to all portfolios on Covestor that are determined based on the portfolio’s strategy, holdings and other factors.

For investors, we also have a short questionnaire that assists Covestor in determining a client’s corresponding Risk Score, to help ensure investors don’t allocate money to portfolios that may exceed their risk tolerance.

As you can see, at Covestor we give investors as much information as possible so they can clearly understand the risk of all the portfolios before they invest. When it comes to transparency, we believe more is always better.

To try Covestor, open a free trial account.

Photo credit: evgie via Flickr Creative Commons.

Disclaimer: All investments involve risk and various investment strategies will not always be profitable. Neither the information nor any opinions expressed constitutes investment advice and is not intended as an endorsement of any specific portfolio manager. Covestor has over 100 portfolios which can all be compared here. Past performance does not guarantee future results.