A portfolio ratio is an important tool for investors to evaluate risk-adjusted returns to see if they are being adequately compensated for the risk they are assuming.
Investors can easily look up portfolio ratios such as Rate of Return and Sharpe Ratio from the performance reports prepared by financial institutions. There is a less-known yet simple ratio called Calmar Ratio also included here because it is practically more important for investors who are more concerned about capital losses due to poor timing.
Why are portfolio ratios important to investors?
Investors can easily look up portfolio ratios such as Rate of Return and Sharpe Ratio from the performance reports prepared by financial institutions. There is a less-known yet simple ratio called Calmar Ratio also included here because it is practically more important for investors who are more concerned about capital losses due to poor timing.
Why are portfolio ratios important to investors?
- help measure the performance of your investments as compared to other alternatives
- help decide and select the best investment choices which match your investment risk tolerance level
- help evaluate the value of your advisors to whom you pay a fee to manage your investments
- help understand risk and reward trade-offs for asset allocation
Rate of Return
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Rate of Return is the measure of return on investment. Perhaps no number is more important to investors than the rate of return (RR) on their portfolio. Unfortunately, many investors have no idea how to measure or interpret their returns properly. If you’ve made contributions or withdrawals during the year, calculating your rate of return is not straightforward.
RR calculations fall into two general categories: time-weighted and money-weighted. If a portfolio has no cash flows (that is, the investor makes no contributions and no withdrawals), both methods produce identical figures. The key point to understand is that any differences in reported returns come about as a result of cash inflows and outflows. A time-weighted rate of return (TWRR) attempts to eliminate the effect of cash flows into or out of the portfolio. It’s the method used by financial institutions when preparing their published performance reports for investors. TWRR is generally impossible for individual investors to calculate on their own because it requires the value of your portfolio on each day a cash flow occurred. A money-weighted rate of return (MWRR) does not attempt to eliminate the effect of contributions and withdrawals. Because it is highly dependent on the timing of cash flows, the MWRR is not ideal for evaluating portfolio managers or investment strategies. A lump-sum contribution or withdrawal can cause the portfolio’s MWRR to outperform or under-perform its benchmark, which is highly misleading. Assuming there is no money in and out, it is easy to calculate a traditional compounded rate of return that represents the annual growth rate of an investment for a specific period of time. Rate of Return Formula RR = (EV/BV)^(1/n) - 1 where: EV = The investment's ending value BV = The investment's beginning value n = Years |
Sharpe Ratio
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Sharpe Ratio, developed by William F. Sharpe, is the ratio of a portfolio’s excess return (total return minus the risk-free rate) divided by the standard deviation of the portfolio, which is a measure of its volatility.
The Sharpe Ratio measures the performance of a portfolio compared to the risk taken. The higher the Sharpe ratio, the better the performance and the greater the profits for taking on additional risk. The Sharpe Ratio levels the playing field among portfolios as a measuring standard for performance evaluation. Note that the ratio is distorted if the investments don't have a normal distribution of returns. When excess return is negative, the Sharpe ratio is also negative, which can be counter-intuitive. Sharpe Ratio Formula Sharpe Ratio = (Rx – Rf) ÷ StdDev(Rx) Where: Rx = average rate of return from investment X Rf = risk-free rate (e.g., 3-month T-Bill rate) StdDev(Rx) = standard deviation of Rx |
Calmar Ratio
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Calmar Ratio is a simple yet practical return/risk ratio. This ratio provides a simple and excellent measure of risk-adjusted performance for any portfolios. The Calmar Ratio changes gradually and serves to smooth out the over-achievement and under-achievement periods of a manager's performance more readily than the Sharpe Ratio and its variations.
The Calmar Ratio is based on actual drawdown, not volatility. Drawdown is a better measure of risk than volatility to investors because a long and deep drawdown could trigger investors' panic and emotional reactions for changes. Just measuring volatility doesn’t give a picture of the drawdown risk. As a rule of thumb, a portfolio with a Calmar Ratio of more than 5 is considered excellent, a ratio of 2 – 5 is very good and 1 – 2 is just good. A comparison of Calmar ratios of two portfolios is not required to determine their individual performances; this isn’t the case with other ratios such as the Sharpe Ratio where the answer is meaningful only when you make relevant comparisons. Ratios that depend on volatility are extremely sensitive in the short run; market instability can cause these ratios to jump inanely. This is why Calmar Ratio is normally based on a 3-year time period. The trend of the Calmar Ratio can be handily calculated on a monthly basis. To calculate the Calmar Ratio, the maximum drawdown (in absolute terms) over the last 3 years is first obtained. Calmar Ratio Formula CR = Compound Annualized RR ÷ Absolute Value of Maximum Drawdown |
Other Notable Ratios for Portfolio Evaluation
While there are quite a few portfolio ratios, the most important three ratios are list above. There are other ratios that could also be indispensable tools for investor's in-depth research process. The analysis of portfolio ratios can greatly influence investors' decision to select and evaluate an investment portfolio or an advisory solution. Other significant ratios for portfolio evaluation include
While there are quite a few portfolio ratios, the most important three ratios are list above. There are other ratios that could also be indispensable tools for investor's in-depth research process. The analysis of portfolio ratios can greatly influence investors' decision to select and evaluate an investment portfolio or an advisory solution. Other significant ratios for portfolio evaluation include
- Standard Deviation measures the absolute volatility of a portfolio. As with many statistical measures, the calculation for standard deviation can be intimidating, but, as the number is extremely useful for those who know how to use it, there are many online sources that provide the standard deviations calculation for a portfolio.
- Beta is a measure of a portfolio's sensitivity to market movements. The beta of the market is 1.00 by definition. Beta is very useful when used to measure the risk of a portfolio. One way to calculate Beta is by comparing a portfolio's excess return over Treasury bills to the market's excess return over Treasury bills. A portfolio with a Beta greater than 1 is considered more volatile than the market; less than 1 means less volatile.
- Calmar-Yang Ratio is an improvement over the original Calmar Ratio described above. The improvement allows the Ratio uniformly captures the short-term maximum draw-down which is most beneficial to real-life investors who always concern about the short-term significant volatility much more than the less-meaningful long-term annualized returns. The new Calmar-Yang Ratio can be easily applied to evaluate and compare any investment portfolios on a common basis.
- R-Squared measures the relationship between a portfolio and its benchmark (normally S&P 500). It has a percentage range from 1 to 100. R-Squared is simply a measure of the correlation of the portfolio's returns to the benchmark's returns and thus it is not a performance measure of a portfolio.. If you want a portfolio that moves like the benchmark, you'd want a portfolio with a high R-squared. R-squared is also used to validate the significance of Beta. Generally, a higher R-squared will indicate a more useful Beta figure.