Risk Based Performance Measures
What are “Risk-Based Performance Measures”?
Risk-based performance measures are statistical calculations designed to quantify the degree of risk involved in achieving the return of an investment over a specific time period. They are widely used by investors to compare and assess existing or potential investments with similar features. For example, if two or more investments have demonstrated a similar return profile over five years, those with lower risk will score better risk-adjusted returns. Some of the most popular risk-based performance measures include Sharpe, Sortino, and Treynor ratios.
Key Learning Points
- Risk-based performance measures give investors an indication for investment returns adjusted for the degree of risk involved in achieving it
- They incorporate different interpretations of risk and could work only when comparing investments with similar features
- The main purpose of using these ratios is to assist investors in determining the risk-reward profile of an investment – one of the main principles of investing is that higher risk is expected to be compensated by a higher return
- Sharpe, Sortino and Treynor ratios are among the most popular risk-based performance measures
Sharpe Ratio
The Sharpe Ratio is often used by investors to assess the portfolio’s relative outperformance per unit of the portfolio’s risk. It measures the excess return of an investment relative to the risk-free rate and divided by the standard deviation (also known as volatility). Therefore, portfolios with higher excess returns and/or lower volatility would normally show higher Sharpe Ratios.
Formula:
Sharpe Ratio = (Rx – Rf) / Standard Deviation
Where:
Rx = Actual or expected portfolio return
Rf = Risk-free rate of return
*Risk-free rate is usually considered as the interest achieved on the three-month US Treasury Bill
Sortino Ratio
The Sortino ratio is very similar to the Sharpe ratio, but instead of using standard deviation, it takes the downside deviation of the portfolio. This calculation is very useful as it measures only against the “bad” volatility since positive volatility is a benefit for returns. Same as the Sharpe ratio, the higher the result, the better risk-adjusted returns.
Formula:
Sortino Ratio = (Rx – Rf) / Downside Deviation
Where:
Rx = Actual or expected portfolio return
Rf = Risk-free rate of return
Treynor Ratio
The Treynor ratio is another risk-based performance metric that helps investors determine the amount of excess return generated for each unit of risk taken on in a portfolio. The important detail that differentiates Treynor from the Sharpe and Sortino ratios is that it takes into account systematic risk (which cannot be diversified), measured as beta. Beta shows the security’s tendency to move in response to movements in the overall market, where a beta 1 indicates the portfolio (or the stock) moves in-line with the market and a beta of less than 1 indicates lower price volatility than the market.
Formula:
Treynor Ratio = (Rx – Rf) / Beta
Where:
Rx = Actual or expected portfolio return
Rf = Risk-free rate of return
The Bottom Line
Avoiding risk is not necessarily a positive as it limits the potential upside, so these ratios are more suitable to be calculated over the longer-term, for example five years. In rising markets, a portfolio that uses lower risk relative to the index may struggle to deliver higher returns than more aggressive portfolios, which may enjoy better returns.