risk adjusted return metrics

In short

A friend of mine once bragged that his fund earned 14 percent last year, and I asked him how bumpy the ride had been. He paused, because he had not thought to check. When two investments sit side by side, the raw return only tells half the story. A risk adjusted return measures how much you earned for each unit of risk you carried. The most common version is the Sharpe ratio, which divides the extra return over a safe rate by the volatility, meaning how widely returns swing. A higher number means more reward for the bumps. These measures look backward, so they describe the past, not the road ahead. Pick the measure that fits what worries you most, and compare only like with like.

The whole of it

What it is

I once watched two neighbors compare their garden yields at a county fair. One grew 40 pounds of tomatoes in a drought year, and the other grew 45 in a mild one. Which gardener was better? You cannot say without knowing the weather. Investing works the same way. A return earned through wild swings is not the same as one earned smoothly.

A risk adjusted return metric puts the return and the risk in one number so you can judge them together. Risk here usually means volatility, which is how far returns bounce around their average. Some measures count only the bad bounces. Others measure how deep a fund fell from its peak. Each one asks a slightly different question, and that is worth knowing before you trust any single figure.

The four you will meet most are the Sharpe ratio, the Sortino ratio, the Treynor ratio, and alpha. The Sharpe ratio compares extra return to total volatility. The Sortino ratio is a close cousin, but it counts only downside swings, since nobody complains when returns jump up. The Treynor ratio compares extra return to beta, which is how much an investment moves when the whole market moves. Alpha is the gap between what an investment earned and what its beta says it should have earned. Each of them leans on a safe baseline, often the yield on short term Treasury bills.

How it works

If you are holding a statement and wondering whether a fund earned its keep, the Sharpe ratio is a fair place to start. It takes the fund's return, subtracts the risk free rate, and divides by the standard deviation. Standard deviation is just a plain measure of how spread out the yearly returns are. A bigger spread means a bumpier ride.

Here is the shape of it. The extra return over the safe rate is called the excess return. Divide that by the volatility, and you learn how much excess return you got for each point of bumpiness. No official body sets a cutoff for a good or a poor ratio. A higher number simply means more excess return for each point of volatility, and the number only means something next to another fund over the same window.

The Sortino ratio swaps in downside deviation, which counts only the returns that fall below a target. The Treynor ratio swaps in beta. That makes it best for a piece of a larger portfolio, where the market risk is what matters. Alpha asks a different question altogether. It asks whether the manager added anything beyond simply riding the market. A positive alpha says yes, and a negative alpha says the fund lagged what its risk should have paid.

The numbers, and where to find yours

You will need three inputs. The first is the return of the investment over a set period. Your fund's own page and your account statements list this. The second is the volatility, which many fund fact sheets print as standard deviation. The third is the risk free rate. The safe rate shifts over time, so the site shows it as the current figure, which the official source publishes each year, filled in with its source and date.

For the market side, the Treasury publishes daily yield data on its website, and the Federal Reserve publishes interest rate series through its data pages. Both are primary sources. Fund companies file reports with the Securities and Exchange Commission, and the SEC's EDGAR database holds the prospectus for any mutual fund. The prospectus must show a fund's past performance. Read it for the period the figures cover, because a ratio built on three calm years can flatter a fund.

One more tip. Use the same time window and the same safe rate for every fund you compare. If one ratio uses five years and another uses ten, the comparison means nothing.

A worked example

Let me tell you about a woman named Marlene, who is saving for her daughter's college and wants to compare two funds. She does not want a fight with her nerves every time the market sneezes. Fund A earned an average of 9 percent a year, with a standard deviation of 12 percent. Fund B earned 7 percent a year, with a standard deviation of 6 percent. For the example, she uses a risk free rate of 3 percent, which is her own plain figure and not a current quote.

For Fund A, the excess return is 9 percent minus 3 percent, which is 6 percent. Divide 6 percent by 12 percent and the Sharpe ratio is 0.50. For Fund B, the excess return is 7 percent minus 3 percent, which is 4 percent. Divide 4 percent by 6 percent and the Sharpe ratio is 0.67.

Fund A earned more in raw terms. Fund B earned more for each unit of risk. That was the surprise. Marlene saw that Fund A paid her 0.50 of extra return for each point of volatility, while Fund B paid her 0.67.

Now see what that means in dollars. Say she puts $10,000 in each. Over one year at the average, Fund A grows by $900, to $10,900. Fund B grows by $700, to $10,700. The gap is $200. But in a bad year, one standard deviation below average, Fund A would sit near 9 percent minus 12 percent, which is a loss of 3 percent, or $300 lost on $10,000. Fund B would sit near 7 percent minus 6 percent, which is a gain of 1 percent, or $100 gained on $10,000. So the smoother fund gave up $200 in a typical year, and in a rough year it came out $400 ahead of the other, a $100 gain against a $300 loss. Only Marlene can say whether that trade suits her.

Where it goes wrong

I have seen smart people fall for a pretty number, and I count myself among them. The first trap is trusting the past too much. A ratio is a photograph, not a forecast. A fund with a fine Sharpe ratio can stumble next year.

The second trap is the window. A short, calm stretch can make a risky fund look safe. Pick a period long enough to include at least one rough patch. The third trap is the risk free rate. Change it, and every ratio shifts. Keep it the same across all the funds.

The fourth trap is that these measures assume returns fall in a tidy bell shape. Real markets sometimes crash harder than the bell predicts. Standard deviation can understate the chance of a deep drop. That is why some people also look at maximum drawdown, which is the largest fall from a peak to a low point. It is simple, and it speaks to the fear many of us feel.

Finally, a ratio says nothing about fees, taxes, or your own goals. A fund can score well and still cost too much after tax. Mind the whole bill. A number is a tool. It is not a verdict.

Questions to answer before you leave this page

What am I really afraid of, a slow year or a deep drop, and which measure speaks to that fear? Do I know the time window and the risk free rate behind each ratio I am comparing, and are they the same for every fund? Have I looked at the fund's prospectus on EDGAR to check the period its figures cover? Does a lower ratio come with a fee I can explain, or is it simply costing me more? And when I picture a bad year in dollars, say a $300 loss on $10,000, can I sit through it without losing sleep?