Understanding the Balance: Risk-Adjusted Returns Explained

When choosing a mutual fund, the return it has generated is often the first thing that grabs our attention. But is that enough to make a sound investment decision? Not really.

We need to look beyond just the returns. It’s crucial to consider how consistent those returns have been and how the fund stacks up against its benchmark and peers.

After all, shouldn’t a well-managed fund not only shine in a rising market but also offer some cushion when the market takes a dip?

But there’s another layer to consider risk. How do we know if a fund is truly a good fit for our investment needs?

Evaluating the risks associated with the fund is key. This involves looking at the volatility in returns over time. Volatility, in simple terms, tells us how ‘bumpy’ the ride might be. As they say,

                                “With great risk comes great reward.” 

But does that always hold true?

This is where risk-adjusted returns come into play. The idea here is that there should be a balance between the risk taken and the reward earned.

Shouldn’t a fund manager who takes on more risk be expected to deliver higher returns? On the flip side, if the returns are lower, could that be acceptable if the risk was lower too?

Risk-adjusted returns measure how much return a fund generates relative to the risk it takes. This helps investors understand whether the returns are worth the associated risk.

To help us assess this, there are several measures of risk-adjusted returns. While many metrics are available, we’ll focus on three of the most commonly used in the market today.

The different kind of risk-adjusted returns are

1. Sharpe Ratio

A key tool for assessing risk-adjusted returns. Ever wondered if taking on extra risk is worth the potential reward? The Sharpe Ratio helps answer that question.

Here’s a simple way to understand it:

Imagine you could invest in a government-backed option and earn a risk-free return, often measured by the T-Bill index. This return is known as Rf​.

If you invest in a scheme with some risk, you earn a return denoted as Rs​. The difference between these returns Rs−Rf is the risk premium, or the extra reward you get for taking on more risk.

To see if this reward is worth the risk, we use the Sharpe Ratio. It compares the risk premium to the risk taken, measured by standard deviation.

The formula is

Sharpe Ratio =  (Rs minus Rf) ÷ Standard Deviation

For example, if the risk-free return is 5 percent , and a scheme with a standard deviation of 0.5 percent  earns a return of 7 percent , the Sharpe Ratio would be:

[7 percent −5 percent ] ÷ 0.5 Percent = 4

A higher Sharpe Ratio means the scheme is offering more reward for each unit of risk.

But remember, you should only compare Sharpe Ratios of similar types of schemes. Comparing an equity fund to a debt fund doesn’t give you a clear picture.

2. Treynor Ratio

Next up is the Treynor Ratio, another important tool for evaluating risk-adjusted returns. Curious about how this metric differs from the Sharpe Ratio?

While both measure the reward for taking on risk, the Treynor Ratio focuses on risk relative to the market, using Beta instead of standard deviation.

Here’s how it works,

Just like with the Sharpe Ratio, we start by calculating the risk premium, the difference between the return of the scheme (Rs​) and the risk-free rate (Rf).

But instead of standard deviation, the Treynor Ratio uses Beta, which measures how much a scheme’s returns move in relation to the market.

The formula is :

Treynor Ratio = (Rs minus Rf ) ÷ Beta

For example, if the risk-free return is 5 percent , and a scheme with a Beta of 1.2 earns a return of 8 percent , the Treynor Ratio would be:

(8 percent – 5 percent) ÷ 1.2 = 2.5.

A higher Treynor Ratio indicates a better reward for the risk taken.

However, keep in mind that Beta is most relevant for diversified equity schemes. Comparing the Treynor Ratios of different types of funds might not give you an accurate picture.

3. Tracking Error

Let’s delve into Tracking Error, an essential metric for understanding how a fund compares to its benchmark. Have you ever wondered how well a fund mirrors its index or how reliably it outperforms?

By definition, the Beta of the market is 1. An index fund, which aims to replicate the market, also has a Beta of 1 and should ideally earn the same return as the market. So, what if the returns differ? This discrepancy is measured by the tracking error.

Tracking error was used to assess how closely an index fund tracked its benchmark, with a zero tracking error being the goal.

For index funds, tracking error becomes more significant. A well-performing index fund should have a very low tracking error, indicating a close alignment with its benchmark.

Tracking Error is crucial for index funds because it shows how well the fund is replicating the performance of its benchmark index. A low Tracking Error means the fund is closely aligned with the index, which is the primary goal of an index fund.

Final Takeaway

So, what does this all mean for your investment decisions? When evaluating mutual funds, it’s not just about chasing the highest returns. Shouldn’t you also consider how much risk you’re taking to achieve those returns?

The Sharpe Ratio and Treynor Ratio help you balance risk and reward, while Tracking Error shows how consistently a fund performs against its benchmark.

Isn’t it wise to look at the bigger picture? By understanding these metrics, you can make more informed choices that align with your financial goals, ensuring you’re not just riding the highs but also managing the lows. After all, isn’t investing about finding the right balance that works for you?