When reviewing a portfolio or managed product, advisers and investors are inundated with a variety of performance metrics, some of which may be outside their field of expertise and therefore are ignored in favor of the historical performance.
This is completely understandable given the obscure ratios and Greek letters being thrown out are not often something people are familiar with – nor are we taught through secondary or tertiary education or via professional diplomas and degrees.
However, these metrics are often critical to pair alongside standard performance figures, as they give relevance to how the investment performed relative to the market and what kind of risk/volatility you had to endure to achieve those returns.
Today we’ll demystify the most common risk and performance metrics that the investor will see surrounding a typical managed fund, one of the most common vehicles for investment in 2021.
The two most common Greek letters you will run into investing in equities are ‘alpha’ and ‘beta’, however we cover some of the “first-order Greeks” in this section to give you a running knowledge of multi-asset metrics.
Alpha describes the relative performance of a portfolio/fund (“strategy”) over/under the market, which is generally indicated by a benchmark. You may also see alpha described as ‘excess return’.
You’ll hear the term “generating Alpha” a lot when you listen in to our morning calls with fund manager guests, meaning through active management they look to provide returns in excess of what the broad market achieved.
For example, consider XYZ Australian Equities Fund.
|Performance||3 months (%)||6 months (%)||1 year (%)|
|XYZ Aus Equities||11.20||7.26||9.84|
The bottom row named “Excess Return” represents the fund’s Alpha relative to its benchmark, the ASX 200 index. Note that Alpha can be both positive and negative depending on if the investment out/underperforms its market, though generally you will hear the term Alpha referring to positive/outperformance.
Unlike Alpha, Beta measures risk not performance.
Beta relates to volatility – specifically, it describes the relationship between a strategy and the market. In other words, Beta measures how closely the strategy follows the movements of the market.
The value of Beta can be interpreted like so:
|Value of β||Meaning||Change if market increases 1%|
|β = 1||The strategy is exactly as volatile as the market||+ 1%|
|β > 1||The strategy is more volatile than the market||More than +1%|
|0 < β < 1||The strategy is less volatile than the market||Between 0% and + 1%|
|β = 0||The strategy is uncorrelated to the market||Unrelated|
|Β < 0||The strategy is negatively correlated to the market||Less than 0%|
One thing to bear in mind is that beta is only meaningful against relevant benchmarks. If you are considering an Australian Equities portfolio, each of the stocks in that portfolio should be included in the benchmark (unless you are trying to provide negative correlation).
Here we enter the world of options, but these next few Greeks are worthwhile knowing since certain portfolios and strategies can be impacted by options and derivatives practices for hedging. Don’t worry, it’ll be brief.
Delta is a measure of how much an option price changes relative to a $1 change in the price of the underlying asset. This is also known as ‘price sensitivity’.
There are both ‘put’ and ‘call’ options out there, but for now we’ll leave a full exploration of that market to another note, so we assume that investors only look at call options: this option gives you the right to buy the underlying asset. Call options have a Delta range between 0 and 1.
If ABCOA:ASX (the option for ABC:ASX) has a Delta of 0.7, that means that for every $1 increase in ABC, ABCOA will appreciate by $0.70. Similarly, if the Delta is 0.1, for every $1 increase in ABC, ABCOA will increase by $0.10.
If you are looking at an ‘equity income’ fund in the future, there’s a good chance that they are using options to hedge their market risk, so Delta rates will form the ratio of how many options they will need to buy at any time.
Rho is a name you may not have heard before, but it is also known as ‘interest rate sensitivity’.
All else being equal, a change in interest rates will impact the price of a call option in proportion to whatever its Rho value is. Typically, the Rho value will be highest when there is the longest time until it expires, since interest rates are generally a long-term economic factor.
As an example, let’s return to the call option ABCOA:ASX.
ABCOA may have a Rho of 0.1, with a market price of $1.00.
If our interest rates rise by 1.00%, then the price of ABCOA will increase by $0.10, in line with Rho.
This is important for certain strategies that have long holding periods and look to hedge interest rate fluctuations through the use of options.
Alongside the Greeks, you may see performance ratios amongst the analysis of how a strategy performs. Breakdowns like the one below are common to find on research reports such as Morningstar.
In this note we’ll explore the Sharpe ratio, as well as the Sortino ratio – both which are important measures of how the strategy handles the balance between risk and return.
The Sharpe Ratio measures the return of an investment (historical) versus the risk it takes. It takes into account something called the ‘risk-free rate’- which in Australia we generally classify as the 10-year Government Bond yield.
The ratio is the averaged return above the risk-free rate per ‘unit’ of volatility.
To put that simply, the higher the Sharpe Ratio, the better return the strategy has made with a given amount of risk.
It is very important to look at the Sharpe Ratio before you become impressed with a fund’s high returns – if the ratio is high, then their risk-adjusted returns are actually high and their performance is not just attributed to high risk, but if the ratio is low then the fund may have just taken a lot of risk to make those returns.
The Sortino Ratio is similar to Sharpe, in fact it is a variation – the difference being that Sortino aims to separate ‘harmful’ volatility from overall volatility. Like the Sharpe Ratio, Sortino considers the risk-free rate and performance above this hurdle.
To keep things simple, the Sortino Ratio ratio only considers the downside risk of the portfolio, whilst leaving the benefits of positive volatility.
Sortino is another worthwhile metric to pay attention to before taking a strategy’s performance at face value. Whilst Sharpe is broader, Sortino can show the investor the return based on the manager’s handling of downside risk – does the fund have to risk huge drawdowns to produce a small gain?
Once again, we want to see the highest number possible for this ratio.
The Devil’s in the Detail
Whilst raw performance (%) numbers are tempting to consider in a vacuum, they often do not tell the whole story.
As investors and advisers, you have access to a range of metrics provided by all manner of public sources on strategies of interest – just as one does due diligence with the financials of a company, so too should you consider all the information around performance.
The difference between a strategy with high alpha, a high Sortino ratio and an acceptable beta level versus a fund which underperforms its benchmark, has to take massive risk and is twice as volatile as the market can be made clear with just a few numbers – all you need to do is know what they’re trying to tell you.
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.