There's no one measure to rule them all, but four metrics can be very instructive
With the recent coronavirus-driven volatility fresh on investors’ minds, there should be a natural desire to review the amount of risk they’re carrying in their portfolios. For Canada-domiciled mutual funds and ETFs, the CSA’s risk-rating provides a rough-and-ready reference for average Canadians.
But those who say the CSA methodology falls short may be looking to bolster their investment decisions with other metrics. For those, four alternative measures could be helpful.
Arguably the most basic measure is the Sharpe ratio, which measures the amount of marginal return an investment provides over a risk-free asset per unit of added risk. As explained in the Wall Street Journal, it’s calculated by taking the difference between a fund portfolio’s average rate of return and that of a risk-free asset, and dividing that number by the standard deviation of the fund portfolio’s returns; the higher the ratio, the safer the fund.
Because it couches risk in terms of return volatility, the Sharpe ratio is easy to understand and therefore widely embraced. But in 2007, that metric indicated that U.S. equity funds were safe on a risk-adjusted basis — right before many of those same funds collapsed in the global financial crisis.
That’s why some portfolio managers have favoured the Sortino ratio, which puts more emphasis on downside volatility. Like the Sharpe ratio, it takes the difference between a riskier asset’s and a risk-free asset’s rate of return. But it divides the resulting number by the riskier asset’s downside deviation — the degree to which its returns descend below the lowest return rate that a given investor can tolerate.
Comparing the Sortino ratios of two portfolios with similar returns will reveal which is better at managing risk, particularly amid volatile or plunging markets. “A higher Sortino ratio identifies a portfolio that earns more for every unit of risk that it takes,” the Journal said.
Downside capture, a twist to the Sortino ratio, calculates a fund’s risk-adjusted return as a function of a given benchmark. That is, it shows whether a fund has lost less than a broad-market benchmark during periods of market weakness, and by how much if so. That third measure is derived by taking the ratio between a fund’s monthly return by the index’s return during the benchmark’s down period, with a score under 100 indicating that a fund lost less than its associated benchmark.
Finally, investors may also turn to Morningstar risk ratings for guidance. As noted by the Journal, those ratings capture certain aspects of risk that can’t be boiled down to one number.
Aside from scoring funds on a 1-to-5 scale, with 5 being the highest, the research firm emphasizes whether a fund is “low risk” or, for those that fall into the bottom deciles, “below average.” Morningstar also goes the extra mile by comparing how well a fund has done in volatile or bear markets versus others in the same category.
“You may have a fund that looks like it’s low risk and just hasn’t encountered a bear market,” Morningstar portfolio strategist Amy Arnott told the Journal. “Looking at historic trends can be a good starting point, especially if a fund has a longer track record, but it’s really hard to get a complete picture without digging into the portfolio.”
