When assessing an investment’s returns, it’s important to take into account the risk it takes to deliver them. Two investments can have identical returns, but the amount of risk taken to achieve those returns can vary significantly. For example, one equity fund may earn a 12% annual return consistently, while another may also yield the same but with higher volatility.
In these cases, just the raw returns can mislead investors. That’s why assessing risk adjusted returns is important as they allow investors to understand whether the returns justify the risk they’re taking to earn them. When adjusted for risk, the returns of such volatile investments come out to be lower compared to stable investments.
Here, we’ll get into all you need to know about risk adjusted return meaning, types, and advantages.
What is a Risk-Adjusted Return?
Risk-adjusted returns are simply metrics that inform us about how well an investment delivers returns compared to the amount of risk it takes. Naturally, every investor would want to earn the highest possible returns while taking the lowest possible risk. Risk-adjusted returns give them a way to compare investments not just on the basis of returns but also on the risks taken to achieve those returns.
For example, risk-adjusted returns are commonly used by mutual fund investors. Two funds may have similar past returns, but one may have more attractive risk-adjusted returns. In such a case an investor would want to go with the fund exhibiting more appealing risk-adjusted ratios as it implies that the fund has generated returns more efficiently as it is taking on less risk.
Now you may be wondering, what is a risk adjusted return? Is it a specific metric? Well, it’s more of a concept that includes different metrics and ways to measure risk. Sharpe Ratio, Sortino Ratio, Treynor Ratio, Standard Deviation, Alpha, and Beta are all different types of risk-adjusted ratios which give investors a unique perspective on how risk and returns are measured. For example, if two funds within the same category have identical returns, the fund with the higher Sharpe Ratio delivers a better risk-adjusted return.
Why Are Risk-Adjusted Returns Important?
Risk-adjusted returns show investors the bigger picture of an investment’s performance as they measure it relative to risk. Investors can use these ratios to compare different investments, so they can choose the one that delivers higher returns by taking less risk, that is, the more efficient investment. Different investors also have different risk appetites, and risk-adjusted returns can help them align their investments with their unique risk tolerance.
Common Metrics for Risk-Adjusted Returns
Here are a few ways risk adjusted returns are measured:
1. Standard Deviation
Standard deviation refers to volatility. Over a period, a stock’s price or a mutual fund’s NAV goes up and down around an average value. This up and down movement is called a fluctuation, and it is measured by standard deviation. Let’s understand this with an example.
Suppose Stock X had an average return of 15% over a year. In the same period, Stock Y also managed to generate the same percentage. If the standard deviation for Stock X is 5% and Stock Y is 3%, then Stock X would be considered more volatile than Stock Y.
Here’s why – Stock X can have a wider range of potential returns due to its higher standard deviation. It can either rise by 5% or fall by 5% and ultimately return somewhere between 10% and 20%. Stock Y comparatively has a much lower range of 12% to 18%, which makes it less volatile.
2. Alpha
Investments have benchmarks that are used as a standard for assessing the performance of an asset. The purpose of a benchmark is to give investors a point of comparison, so they can understand how well an investment has performed compared to the overall market. Alpha measures how much more returns an investment earns relative to its benchmark. For example, if Nifty 50 generated 14% returns and a fund returned 13%, it underperformed with an Alpha -1%.
The purpose of investing in an actively managed fund is to generate higher returns than the relative benchmark. In other words, to create positive Alpha. Index funds track benchmarks, so they don’t generate any Alpha.
3. Beta
- Beta measures the systematic risk of an investment relative to the broader market. The baseline for Beta is always 1. Now,
- If an investment’s Beta is equal to 1, that means its returns tend to move in line with the market. Thus, the Beta of an index fund would also be 1.
- If the Beta is greater than 1, let’s assume 2, that suggests when the market increases by 5%, the investment can increase by 10%. Similarly, if the market goes down by 5%, the investment would go down by 10%. Volatility for such assets is thus higher.
- If the Beta is lower than 1, it means the investment is less volatile than the market. Thus, a lower Beta means the investment is more stable.
4. Sharpe Ratio
The Sharpe ratio is one of the most widely used risk-adjusted metrics among investors. This ratio compares the excess return an investment generates, i.e., the return above the risk-free rate, to the total standard deviation. The Sharpe ratio is given by:
Sharpe Ratio = (Rp – Rf) / SD
Here,
- Rp = Return on investment
- Rf = Risk-free return
- SD = Total standard deviation
- (Rp – Rf) would give us the excess or extra return
The risk-free rate here refers to the return of an asset which would allow an investor to earn without any risk of losing their principal. An example of such a security could be a Government bond. Essentially, this ratio measures how much more an investor earns by investing in a risky asset compared to a risk-free one and dividing it by the volatility of the asset.
A high Sharpe ratio indicates that an investment is earning a higher return compared to the total risk it is taking on.
5. Treynor Ratio
The Treynor ratio works a bit like the Sharpe ratio, however, instead of the total standard deviation it measures the extra return against Beta. Treynor Ratio is calculated using this formula:
Treynor Ratio = (Rp – Rf)/ Beta
Where,
- Rp = Return on investment
- Rf = Risk-free return
- Beta = Measures systematic risk
Just like the Sharpe ratio, a higher Treynor ratio suggests that the investment is earning more return per unit of systematic risk taken.
6. Sortino Ratio
This is yet another ratio that is similar to the Sharpe and Treynor ratios, but instead of considering total volatility or systematic risk, it considers only downside risk. Downside risk, or downside standard deviation focuses only on negative deviations around the average. Its formula is:
Sortino Ratio = (Rp – Rf)/ DSD
Here as well,
- Rp = Return on investment
- Rf = Risk-free return
- DSD = Downside standard deviation
If an investor’s priority is to avoid loss, then the Sortino ratio can be very valuable as it showcases a fund manager’s ability to protect the downside. The higher the Sortino ratio, the better.
How to Calculate Risk-Adjusted Returns?
Each ratio has a different risk adjusted returns formula. Let’s take a look at how one can calculate risk adjusted return based on the Sharpe ratio:
The Sharpe ratio is given by
Sharpe Ratio = (Rp – Rf) / SD
Where,
- Rp = Return on investment
- Rf = Risk-free return
- SD = Total standard deviation
Suppose two funds, X and Y have the following returns and standard deviations:
| Fund X | Fund Y | |
| Returns | 11% | 14% |
| Standard Deviation | 5% | 10% |
The risk-free rate for both would be the same, as it is usually the return of government securities. Let’s assume the risk-free rate in this case is 6%.
Sharpe ratio for Fund X:
Sharpe Ratio = (11 – 6) / 5
Sharpe ratio = 1
Sharpe ratio for Fund Y:
Sharpe Ratio = (14 – 6) / 10
Sharpe ratio = 0.8
Even though Fund Y yielded higher returns, Fund X delivered better risk-adjusted returns. In other words, Fund X delivers better returns per unit of risk it takes.
Advantages of Using Risk-Adjusted Returns
There are many reasons to assess risk-adjusted returns before investing. Metrics like Alpha and Beta can help investors understand how well an investment is doing relative to its benchmark. If a fund has a higher Alpha, it means that the fund manager added value beyond what would be expected from the market. Similarly, a Beta closer to 1 suggests the investment has the same level of volatility as the market and moves in line with it.
Using the Sortino ratio can help conservative investors looking to reduce downside risk. On the other hand, the Treynor ratio can be used to evaluate an investment’s return based on its systematic risk, and the Sharpe ratio to determine returns per total risk. Each of these has a unique purpose and gives different insights.
Limitations of Risk-Adjusted Returns
Risk-adjusted returns are not without limitations. Investors should fully understand what they mean before drawing inferences from them. For example, a conservative investor may think that an option with low Beta would suit them as it indicates low volatility. This can be misguided as Beta doesn’t tell us anything about the inherent risk of an asset, only the relative risk.
Another thing to keep in mind is that risk adjusted returns heavily depend on past data. While past data should be thoroughly analysed, remember that good historical performance does not guarantee good returns in the future.
For most investors, it isn’t about avoiding risk, but rather aligning their investments with their risk profile. Returns scale with risk, so avoiding risk altogether can be a suboptimal approach. For example, a fund taking a lower risk than its benchmark may hold back the returns investors are hoping for.
On the other hand, a fund that takes on more risk than its benchmark can deliver higher returns. Such funds may belong to the high-risk equity category which can suffer losses during volatile times, but over a long period, they have a better chance of outperforming their benchmarks.
Conclusion
Simply put, risk adjusted returns tell you whether the risk you’re taking is worth the reward you can potentially get. Some examples of these risk/return measures include the Alpha, Beta, standard deviation and risk-adjusted ratios like Sharpe, Sortino, and Treynor Ratios.
High Alpha, along with high Sharpe and Sortino ratios suggest better returns relative to risk.
On the other hand, lower Beta and standard deviation indicate an investment is less volatile.While these are great tools to assess the worth of an investment relative to risk, they should not be looked at in isolation. The best investment is not necessarily one that takes lower risk, but rather one that aligns with the investor’s financial goals and risk tolerance.
