It can be easy to forget when caught up in day-to-day events and headlines that we’ve been through an incredibly benign and profitable period for any individual or organisation investing in financial markets.
One way of illustrating this, which we particularly like is to look not just at the returns that have been generated, but a measure of risk-adjusted return. In other words, the amount of return per unit of risk. Specifically, we look at the Sharpe ratio which measures excess return (over the risk free rate) divided by the volatility (one statistical measure of the historical risk).
Why care about Risk Adjusted Return?
Surely its just the return itself we should care about?
The path of a return stream matters. Given a choice I think all investors would prefer a smooth path upwards rather than a rocky ride, you can’t make the path perfectly smooth of course but understanding the risk-adjusted return properties of different assets can help us improve the ride.
Not only have returns been very high over recent periods (such as the last 3 or 5 years), risk has been very low. So in risk-adjusted terms it’s been a bumper time for investors with many asset classes and strategies registering Sharpe ratios in excess of 1 over the last 3 and 5 year period (see chart below), which is far in excess of what we would expect over longer time periods (see second chart below which illustrates risk adjusted returns over the last decade as a comparison).
Investors can count themselves lucky to have experienced such a good run, but it’s important to step back and consider this in a wider context which leads to a few conclusions:
– Investor’s shouldn’t anchor to recent returns or sharpe ratios when forecasting returns or setting allocations going forward. Usually you have to take a lot more risk to generate the sort of returns we’ve seen (alternatively you have to accept lower returns for similar levels of risk)
– Any investment strategy with a track record of less than about 3-5 years needs to be viewed carefully, usually this would be considered a decent history, but with almost all asset classes having had such a great run there have been few real tests for such strategies. Consequently there are a great many funds and strategies out there have developed excellent track records
– Strategies that can blend different sources of return (risk premia) are likely to give a more stable ride over longer time periods (ie, have better risk adjusted returns) than a single risk premium. this is evidenced by the performance of strategies such as Risk Parity, which has the highest sharpe ratio over the last 10 years.
The charts below are extracts from Redington’s quarterly Risk Adjusted Returns report which can be found here