By now you may realise that investing is not just about seeking return. Risk attributes are an equally important part of this journey. When it comes to selecting managed funds, it’s risk-adjusted returns that can make all the difference.
Whether it is choosing funds from within a category or choosing funds across different categories, risk-adjusted returns can help you decide where you are maximizing the efficiency of your choice.
What does it measure?
When you look at return by itself, you are essentially considering the return a fund has delivered in a fixed period of time. In the case of market-linked products, like mutual funds, the return figure can look different depending on the time period chosen.
Moreover, return is highly impacted by daily activity in the market, news flow and other external factors. This causes frequent fluctuations in daily price and sometimes, the fluctuation can be sharp too.
As a result, what occurs is short term volatility in returns, which can become a risk depending on when you want to sell or exit your investment.
When we measure risk adjust returns it is this fluctuation or volatility that is measured against the delivered return. What it tells you, is the return you can earn per unit of risk. Higher the return relative to risk, the more efficient your investment choice is.
Among two or more comparable funds, ideally, one would prefer the fund which can deliver the same return but with lower volatility.
Risk-adjusted returns can be used to measure the efficiency of returns among funds in one category and across categories; comparing the efficiency of pure equity funds against aggressive hybrid funds is one such use for risk-adjusted returns.
How can you measure it?
There are fixed formulae that one can use to measure risk-adjusted returns. However, if you are not one for tedious calculations, certain ratios used to measure this are published online as well. The simplest one to watch out for is the Sharpe Ratio. What this ratio tells you is the excess return or return of a fund above the return achieved with the lowest possible risk, per unit of its volatility.
It is measured for defined periods of time and the higher the ratio, the better the risk-adjusted return of the fund is. Hence, where you need to be mindful is in making investment choices with consistently high or low Sharpe ratios.
The former will add stability to your portfolio without compromising return, whereas the latter can cause fluctuations in your portfolio return, with the potential of leaving you vulnerable at your desired time of exit.
Risk-adjusted returns are most efficiently used for market-linked investments where daily price volatility can affect the return outcome at the time of exit. This can manifest in both short- and long-term holding periods.
Sharp and sudden price changes are not unseen in equity markets; such events are usually driven by external factors but in the interim impact your withdrawal value in case you want to exit at that time.
Using risk-adjusted returns can also prove useful in comparison among fund categories like large-cap, mid-cap and hybrid funds.
Being aware of this can further help you make more efficient long term investment choices, rather than just chasing the high expected return from a category of funds.