Thursday, 19 May 2016

Using ratios to aid investment decisions

How ratios can aid investment decisions.

Most investment fund managers use quantitative analysis (mathematical modelling) to some extent in assessing where to commit their assets to. Indeed, there are managers who only use quantitative criteria in their decision-making processes. Part of that analytical process will involve looking at historical performance, and gauging it by a series of ratios and measurements.

When considering your own investments, the decisions cannot hinge solely on the amount of return that a fund generates. Investors will also want to consider other factors: what degree of risk was assumed in order to make that return? By how much has the fund outperformed a notional risk-free investment? Has the manager demonstrated skill in adding extra returns, or merely tracked the fund's benchmark?

Answers to these questions can be found in the performance measurements available on most fund factsheets. There are three key ratios that can help to differentiate between funds and these are the Sharpe ratio, the Alpha ratio and the Beta ratio.

The Sharpe Ratio

This is a commonly-used measure which calculates the level of a fund's return over and above the return of a notional risk-free investment, such as cash or Government bonds. The difference in returns is then divided by the fund's standard deviation - it's volatility, or risk measurement. The resulting ratio is an indication of the amount of excess return generated per unit of risk.

Sharpe is useful, when comparing similar portfolios or instruments. There is no absolute definition of a 'good' or 'bad' Sharpe ratio, beyond the thought that a fund with a negative Sharpe would have been better off investing in risk-free government securities. But clearly the higher the Sharpe ratio the better: as the ratio increases, so does the risk-adjusted performance. In effect, when analysing similar investments, the one with the highest Sharpe has achieved more return while taking on no more risk than its fellows.

The Alpha and Beta Ratios

Alpha is a measure of a fund's over- or under-performance by comparison to its benchmark. It represents the return of the fund when the benchmark is assumed to have a return of zero, and thus indicates the extra value that the manager's activities have contributed: if the Alpha is 5, the fund has outperformed its benchmark by 5%, and the greater the Alpha, the greater the outperformance.

Beta is a statistical estimate of a fund's volatility by comparison to that of its benchmark, i.e. how sensitive the fund is to movements in the section of the market that comprises the benchmark. A fund with a Beta close to 1 means that the fund will generally move in line with the benchmark. Higher than 1, and the fund is more volatile than the benchmark, so that with a Beta of 1.5, say, the fund will be expected to rise or fall 1.5 points for every 1 point of benchmark movement. High Beta is, therefore, an advantage in a rising market - a 15% gain for every 10% rise in the benchmark - obviously the converse is the case when falls are expected. This is when managers will look for Betas below 1, so that in a down market the fund will not perform as badly as its benchmark.

When Alpha is taken in conjunction with Beta, a fund with negative Alpha and 1+ Beta is an indication of poor performance: managers are subjecting funds to volatility that is higher than the benchmark, while achieving returns that are lower than the benchmark attained. So, if Alpha indicates better/worse performance compared with the index, Beta shows higher/lower risk.

As always seek advice where appropriate when making investment decisions.

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