Researchers have found that most active managers underperform their appropriate benchmarks most of the time after adjusting for risk and fees [1]. Despite the widespread underperformance of most actively managed funds, investors frequently receive calls from their financial advisors informing them of “attractive” or “fantastic” investment opportunities that are capable of beating the market. However, these opportunities often prove to be disappointing.
The truth is that investors are often not adequately informed about the concept of risk-adjusted returns and are frequently presented with investment products that have produced large gains over a relatively short period. Given that most investors are unable to objectively evaluate probability and risk, such presentations often lead them to chase returns and harm their investments.
While the concept of risk-adjusted returns, or evaluating investment gains in relation to risk, is not new, it is often not properly presented to investors by financial advisors. The average investor generally lacks the necessary framework for evaluating investment portfolios, and instruments properly.
Therefore, the purpose of this article is to present a simple framework to measure, evaluate, and compare the performance of an investment portfolio or investment fund. At Rockstead Capital, we also use this framework to objectively evaluate and improve the performance of our clients’ investment portfolios and in-house funds.
Based on the framework, a portfolio is considered superior if it has the following characteristics.
- Portfolio produces high risk-adjusted benefits.
- Portfolio generates returns with low correlation to financial markets.
- Portfolio experiences low maximum drawdown.
- Portfolio can recover quickly from losses when they occur.
- Portfolio delivers stable and well-distributed positive returns.
RISK-ADJUSTED BENEFITS
When investors compare the performance of two investment portfolios, they should consider not only the returns produced by the investments but also the amount of risk taken to earn these returns.
The Sharpe Ratio is one of the most popular methods of adjusting investment return rates for risk. Originally referred to as the reward-to-variability ratio, the Sharpe Ratio was developed by William F. Sharpe in 1966 and revised in 1994 to become the formula used today.
The Sharpe ratio calculates the excess return (return above the risk-free rate) of an investment or portfolio per unit of its volatility or risk. The higher the ratio, the more an investor is rewarded for the risk that they are taking.
There are multiple ways to measure risk-adjusted returns, including Alpha, Beta, R-squared, etc. However, the goal of this article is not to discuss the mathematics and limitations of each metric. Rather, we seek to help investors understand that the naive approach of evaluating investment performance solely based on absolute returns may lead investors to invest in an inferior portfolio. In other words, a portfolio manager’s efforts to optimise their portfolio’s risk-adjusted returns are more relevant than their choice of risk-adjustment metrics.
Simply by observing the graphs below (without applying any mathematical formula), one can easily conclude that portfolio A is superior to portfolio B, even though the eventual outcomes (or absolute returns) of both hypothetical portfolios are the same.
Investors may want to note that the Sharpe ratio of the S&P 500 index from 1992 to 2022 is around 0.64. Generally, any investment portfolio that has a Sharpe ratio of 1 or greater is considered good. Our goal at Rockstead is to maximize the risk-adjusted returns (not merely absolute returns) of our investment portfolios. Investment portfolios that we typically construct for our family office clients often have Sharpe ratios as high as 2.
DECORRELATION
Asset correlation measures the movement of investments relative to one another. When assets move in the same direction at the same time, they are positively correlated. When one asset tends to move up while the other goes down, the two assets are negatively correlated.
The correlation between two investments can be measured using a statistic known as Pearson’s correlation coefficient, or simply the correlation coefficient. Mathematically, it is a statistical measure of how two variables move in relation to each other. This measure ranges from minus 1 to positive 1, where minus 1 indicates perfect negative correlation and positive 1 indicates perfect positive correlation.
In the context of the Rockstead Portfolio Construction Framework, we are interested in seeing how a portfolio correlates with various financial markets. One may ask, why is such correlation analysis important?
Simply put, an investment portfolio that has low correlation with the market offers protection to its investors, especially during economic downturns or times of global equity sell-offs.
One of the key objectives of the framework is to enable us to construct investment portfolios that are market-neutral. In other words, we favor portfolio returns that are independent of the direction of the market. This is achieved by taking long and short positions in a variety of assets to cancel out market exposure.
By cancelling out market exposure, a market-neutral portfolio is less exposed to market volatility and market risks. This can result in more stable and predictable returns over time. During market downturns, a market-neutral portfolio can also help investors preserve capital, making it an attractive investment for risk-averse investors.
SIZE OF EXTREME LOSSES
“Drawdown” is the percentage of decline from the highest point to the lowest point in an investment portfolio or fund. Measuring the maximum drawdown over a certain period is a practical way to quantify the downside risk of an investment portfolio or fund.
Drawdowns present significant risk to investors as the uptick in portfolio value needed to overcome a drawdown can be substantial. For instance, if a portfolio loses 1 percent, it only needs an increase of 1.01 percent to recover to its previous peak, which may not seem like much. However, a drawdown of 20 percent requires a 25 percent return to reach the old peak. During the 2008 to 2009 financial crisis, a 50 percent drawdown required a 100 percent increase to recover the former peak.
Limiting drawdown risk is crucial, and we extensively stress-test our portfolios. Our portfolio construction framework dictates that we don’t implement any investment portfolio that has a maximum drawdown of more than 15 percent during periods of extreme market downturn, such as the great financial crisis of 2008.
RECOVERY
When considering the downside risk of a portfolio, it is imperative to not only consider the extent of drawdowns but also how long it takes for a drawdown to be recovered.
A 25 percent drawdown in one investment portfolio may take years to recover. On the other hand, another well-constructed portfolio may recover losses in a matter of months, pushing the portfolio to its peak value in a short period of time.
The unfortunate truth is that equity market declines of this magnitude, and worse, occur from time to time. There have been 11 occasions in the 148 years between 1871 and 2019 when equities (as measured by the S&P 500 Index) have destroyed at least 25 percent of value for investors (see table below). In the 2001 and 2008 downturns, losses exceeded 40 percent.
In the worst case, the Great Depression of the 1930s, investors lost over 80 percent of their money. It took over 15 years for them to recover their money if they remained invested.
References:
[1] SPIVA (S&P Indices Versus Active) 2022 report produced by S&P Dow Jones Indices
