It can be difficult to decide on a strategy and investment team in a sea of performance statistics. There is no perfect statistic or number for selecting a specific strategy; however, we believe some measures can be useful. This essay will walk through the common metrics used when discussing portfolio performance and provide some context for these numbers.
Deciding on an investment team is much like buying a vehicle. There are flashy statistics like horsepower and 0-60 times, but for most people, a Corvette is not a good choice for an every-day driver. Ideally, a vehicle is reliable, affordable, fuel-efficient, and safe. Driving, like investing, has risk. Good vehicles are designed for the worst-case scenario, like mechanical failures or accidents, while good managers plan for recessions and market panics.
When assessing investment options, the first thing many investors look at is historical returns: if a strategy has outperformed its benchmark, it is viewed as a good strategy. If it underperforms its benchmark, investors start to question the strategy. However, returns do not tell the whole story. Risk plays a significant role in the performance results of a portfolio. Strategies that take on a lot of risk can look great in boom times, but become exposed when the bull market recedes.
The difficulty for investors is measuring risk. Admittedly, this is a complicated task, especially in a portfolio of 40-plus companies, each with exposure to a variety of geographies, markets, industries, cyclicalities, and other risk factors. It is partially because of this difficulty that the industry and academia have come up with a useful shorthand measurement for risk: volatility.
While volatility is not the perfect measure for risk and is only one (very small) factor among many that Managed Asset Portfolios’ (“MAP”) investment team weighs when analyzing companies, it helps evaluate past performance. Theoretically, a riskier strategy will be more volatile. This does not always hold true, and volatility can vary over time periods. However, it is the best shorthand measurement available.
Returning to the car analogy, it is useful to think of return as the flashy statistics of a vehicle (i.e., horsepower and top speed), while risk is more like a reliability rating, safety rating, or fuel efficiency metric. Every purchaser of a vehicle has a different combination of need and preference, just like every investor will have a different risk tolerance profile.
While MAP’s marketed strategies have historically had return numbers to be proud of, we are more interested in our risk-adjusted numbers. Assessing risk is an essential part of our process, and we want to know how well we have vetted risks before investing.
Essential when considering these statistics is the period over which they are measured. Some strategies will appear great in bull markets but struggle in bear markets, while others will succeed in bear markets and lag in bull markets. The best way to evaluate a strategy is its performance over a complete market cycle. Additionally, investment team continuity is essential. Managers who maintain their core portfolio team set themselves up for success. Outperformance over the long run and investment teams that have kept leadership in place are solid foundations for assessing a strategy.
Given this foundation, let’s dive into some useful metrics.
No metric is perfect or comprehensive, but some are better than others. Here are some standard metrics used for evaluating a strategy’s historical performance. Keep in mind: it is not easy to evaluate performance based on these numbers in a vacuum, so it is useful to compare these statistics within peer groups.
Sharpe Ratio is the original risk-adjusted performance measure as well as the most popular. Developed by William Sharpe in the 1960s, the Sharpe Ratio can be found in most historical performance discussions. The Sharpe Ratio is calculated by subtracting the risk-free rate (US Treasury bonds are often used as a proxy) from a portfolio’s return. This number is then divided by the standard deviation of historical returns. Higher Sharpe Ratios indicate better historical risk- adjusted-performance.
While this measure is the most common among risk-adjusted statistics, it has a crucial flaw: it penalizes strategies with upside volatility. Upside volatility should not count against performance, and in fact, could mean that the strategy is doing its job: providing attractive returns. No one has ever been upset by an unexpectedly large gain. Because of this flaw, MAP prefers other measures for evaluating historical performance, such as the Sortino Ratio.
The Sortino Ratio is very similar to the Sharpe ratio, except that it eliminates the critical flaw mentioned above. Rather than accounting for both upside and downside volatility, the Sortino Ratio only counts downside deviation when calculating volatility. A higher Sortino Ratio indicates better performance.
We believe this is a much-improved lens with which to view historical performance. A strategy’s performance should be punished for volatility on the downside but rewarded for large excess returns.
The Treynor Ratio is another useful metric to judge a portfolio’s historical performance. Much like the Sharpe and Sortino ratios, the Treynor ratio’s numerator is the portfolio’s return less the risk-free rate. Also, as with the previous two mentioned ratios, the higher the ratio, the better the portfolio has performed on a volatility-adjusted basis.
However, the denominator is the beta of the portfolio. Beta measures how much the returns of an asset swing compared to a broader market index (in the case of MAP’s Global Equity Composite, we use the MSCI ACWI, gross). This is often called systematic risk, as it measures the exposure to broad market risk, which cannot be wholly avoided when investing in stocks.
The index will always have a beta of 1, and portfolios with a beta of 1 will generally track the market more closely. A lower beta means that a portfolio is less volatile or less correlated than the comparative broader market index. In comparison, a higher beta implies that the portfolio is more volatile than the market or more correlated to the market.
This ratio can be useful when deciding whether to add a new strategy to your portfolio. Portfolios with low betas often face muted effects in broad market downturns, allowing the portfolio to recover more quickly.
Investors should account for risk when assessing investment strategies. While high returns often get the most attention, high historical volatility can indicate that a portfolio has achieved those high returns by taking excess risk.
Think of choosing a strategy like you would select your next vehicle. Horsepower and appearance are nice to have. However, safety and reliability are also an essential part of the process. Many of the flashy and news-grabbing investment strategies have a lot of horsepower and have performed well during bull markets. However, they may not have the long-term track record and emphasis on managing risk.
While no measure of historical performance is perfect, and the phrase “past performance is not an indication of future results” exists for a reason, risk-adjusted metrics are more useful in judging a strategy than pure return. Of the above-highlighted metrics, we believe the Sortino Ratio is most fair for comparing strategies. It accounts for downside volatility while not punishing a portfolio for upside volatility.
Additionally, the long-term performance of a strategy is more reliable than short-term performance. Economies and markets move in cycles, and different strategies will benefit from different portions of the cycle. Portfolios and teams that have been around for entire market cycles and have performed well can be more reliable than strategies that have been around for a short duration and benefited from their portion of the cycle.
Assessing potential risk is an essential part of MAP’s investment process, and historically our team has succeeded in reducing downside volatility. We continue to aim to capture the upside while muting the downside. No one strategy is perfect, and each will sustain periods of underperformance. However, MAP is in it for the long haul. We hope that you are too.
Managed Asset Portfolios Investment Team
Michael Dzialo, Karen Culver, Peter Swan, John Dalton, and Zachary Fellows
Research and analysis by Dustin Dieckmann
Certain statements made by us may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements.