Balancing risk and return
David Prosser explains one way to judge risk when investing.
The chances are that you’ve never heard of William Sharpe, though the Stanford University Professor of Finance did win a Nobel Prize for economics in 1990. But you don’t need to get to grips with the capital asset pricing model that Sharpe developed in order to put his theories to work in your investment activity – and they could help you see investment funds in a new way.
Much of Sharpe’s work centred on measuring investment return in terms of the risks taken to achieve that return. He developed the “Sharpe ratio”, which attempts to provide a standardised yardstick for evaluating the judgement that all investors make – are the risks you take when putting your money into a particular asset or fund justified by the returns on offer?
Are the risks you take when putting your money into a particular asset or fund justified by the returns on offer?
David Prosser
The Sharpe ratio essentially focuses on two components: the return over a given period that an investment generates above an agreed risk-free return (typically what a US Treasury bond has delivered), and the volatility of that performance during the period studied. In other words, the ratio tells you how much performance the investment delivered in the context of the risk that you faced along the way.
In the collective fund universe, risk-adjusted returns are a critical measure of how well a fund manager is doing their job. A fund may deliver relatively low returns, but you may be happy with that performance if you’re a cautious investor and the fund has also given you limited volatility. Equally, you may be prepared to put up with a rollercoaster ride if the performance thrills justify the spills.
The higher the Sharpe ratio, the better the fund in this regard. A higher Sharpe ratio shows that a fund manager has delivered more additional return for each additional unit of risk taken. Investors have been more handsomely rewarded for the volatility they have had to put up with.
The Sharpe ratio isn’t infallible. Most obviously, it’s backwards looking, with all the caveats about past performance being no guide to the future that therefore apply. It can also provide a misleading read-out during investment bubbles and periods of hype.
Still, the ratio is a useful indicator that professionals have often made use of to compare investment funds. Warren Buffet’s Berkshire Hathaway, for example, boasted a Sharpe ratio of 0.79 between 1976 and 2017, a higher ratio than any other comparable fund; the US stock market, by contrast, had a Sharpe ratio of 0.49 over the same period.
Various data providers, including Morningstar and FE Analytics, publish Sharpe ratios so that you can use this measure to compare investment funds you might be considering in a particular sector or area of the market. And investment trust analysts regularly publish analyses of this data.
One recent study from Trustnet is an interesting example. It looked across the UK All Companies, UK Equity Income and UK Smaller Companies sectors to identify investment trusts that have produced a top-quartile Sharpe ratio in at least five of the full calendar years of the past decade.
Just five funds achieved this, Trustnet noted – BlackRock Throgmorton Trust, Mercantile Investment Trust, Finsbury Growth & Income Trust, Edinburgh Investment Trust and Murray Income Trust.
To be clear, these trusts weren’t necessarily the most stellar performers in their sectors over the 10 years to the end of 2024, the period studied, though they did beat their sector averages. Rather, these were the funds that consistently delivered the best risk-adjusted data – their investors received more performance in return for the risks they were subjected to.
Risk-adjusted returns, after all, are what many of us are looking for. We want the best performance possible given the risks we feel comfortable taking. Sharpe ratios can be a helpful way to screen for that objective.
David Prosser
David is former Business Editor of The Independent, Personal Finance Editor of the Daily Express, and Deputy Editor of Money Observer magazine. He writes regularly for the AIC.
