Understanding investment risk: 2 risk measures explained

One of the more common ways to compare unit trusts is to look at their long-term track records. While this is certainly a good start, it’s important to remember that performance doesn’t happen in isolation. In fact, equally important is the risk that comes with generating returns. Although past performance is by no means an indication of future performance, looking at returns and risk in conjunction with each other can provide some insight into how different portfolios behave under different market conditions. For the purpose of this article, we’ll focus on two different performance risk measurements: the Sharpe and Sortino ratios.

Sharpe ratio

The Sharpe ratio is widely regarded as the industry standard for measuring the amount of risk involved in generating returns (also referred to as risk-adjusted returns). To understand how the Sharpe ratio works, it’s important to familiarise yourself with two key concepts:

• Standard deviation: Also referred to as volatility, standard deviation measures the amount of variation in an investment’s return relative to its average over time. The larger the standard deviation, the more volatile the investment.
• Risk-free rate of return: As the name implies, this refers to the return of a risk-free investment. The concept, however, is slightly problematic, as even the safest investment today holds some element of risk. Irrespectively, most fund managers use a proxy that is as close to risk-free as possible, such as South Africa’s money market index, when determining the risk-free rate of return.

The Sharpe ratio is essentially: the average return of the portfolio less the average return of the risk free investment, divided by the average standard deviation of the portfolio. While this might sound slightly complicated, the most important thing to remember is that the higher a portfolio’s Sharpe ratio the better its historical risk-adjusted performance.

While the Sharpe ratio is one way to measure how well a portfolio’s return has compensated investors for the amount of risk taken, it does have some limitations. The calculation assumes that all movement relative to the average is regarded as risk (be it up or down). Most equity investors, however, see the risk of capital loss (downward movement) as a better proxy for risk. For these investors, the Sortino ratio is probably a more useful measurement.

Sortino ratio

The Sortino ratio is very similar to the Sharpe ratio, however it excludes upside volatility as part of the calculation. This means that only ‘bad volatility’ (or the risk of capital loss) is taken into account. The Sortino ratio gives investors an indication of the return a portfolio is able to generate relative to its downside risk, with a higher ratio indicating a better return relative to downside risk.

To demonstrate this point, the graph below shows the 10 best-and 10 worst-performing general equity portfolios measured over a three-year period as at the end of February 2017. The top performing portfolios show noticeably higher Sharpe and Sortino ratios compared to the bottom half.

Important to note is that low Sharpe and Sortino ratios don’t necessarily mean less volatility, and vice versa. Using the above portfolio information, the graph below looks at the annualised returns and standard deviation of the top and bottom portfolios over the three years being measured. What the graph demonstrates is that the bottom performing portfolio is, in this case, slightly more volatile relative to the top performing portfolio. 

With risk being such an important part of the investment process, it’s handy to know what the different risk measurements are and how they work. When choosing the right unit trust for you, these measures can help you understand what to expect from a unit trust in different market conditions, which is especially important if you have a low risk tolerance.

Whether you lack the time or knowledge to make your own investment decisions, it may be worth considering contacting a good independent financial adviser for assistance. Alternatively, for more information please feel free to contact our Client Services Team on 0860 105 775 or at query@prudential.co.za.