Alternative investments are only as good as their performance ratios. While achieving portfolio diversification and reaping alpha are the end goals of many investors, there are several performance ratios that investors can use to evaluate alternative investment opportunities. The below are general performance ratios typically used by investors.
An often-used performance metric, the Sharpe ratio is the industry standard for measuring the risk-adjusted return of an investment. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility, or total risk. It uses standard deviation to measure a fund’s risk-adjusted returns. The greater the value of the Sharpe ratio, the more attractive the risk-adjusted returns.
However, the Sharpe ratio also has its limitations. Sharpe ratios can be misleading when used for portfolios that do not have a normal distribution of expected returns. Since the Sharpe ratio uses the standard deviation of returns in its formula as a proxy of total portfolio risk, it assumes that the returns are normally distributed. The limitation here is that alternative investment returns do not tend to be normally distributed.
Given the Sharpe ratio’s limitations, the Sortino ratio is oftentimes used in tandem. The Sortino ratio is a modified version of the Sharpe ratio that measures a risk-adjusted performance that only penalizes returns that fall below a target rate of return. Since the Sortino ratio does not use the standard deviation (which takes both upward and downward volatility into consideration) as the Sharpe ratio does, the Sortino ratio adjusts the performance for risk by only using the downside risk/deviation. The higher the Sortino ratio, the higher the portfolio return will be over the target rate of return. Therefore, the Sortino ratio is especially helpful when investors are analyzing asset classes and portfolios that are highly volatile, since the ratio focuses on whether returns are negative or below a certain threshold.
Return on Investment (ROI)
One of the simplest performance metrics, ROI measures the amount of an investment’s return relative to the investment’s cost. The higher the ROI, the higher the investment gains are compared to the investment cost. Despite the simplicity behind ROI, it is not adjusted for the amount of time in which investments are made. Therefore, investors also use the Rate of Return, which takes the specific period of time in question into consideration, or the Real Rate of Return, which takes the net present value into consideration alongside the ROI.
The Treynor ratio measures returns earned in excess of that which could have been earned on an investment that has no diversifiable risk per unit of market risk. Just like the Sharpe ratio, the Treynor ratio measures the relationship between annualized risk-adjusted returns and risks. However, the Treynor ratio is different in that it uses “market” risk, or beta, instead of total risk (standard deviation). The higher a Treynor Ratio, the better the portfolio’s performance is under analysis. The Treynor ratio is most helpful when used to understand how well an investment performed given its level of risk – a comparison of a portfolio’s performance per unit of beta.
Most often used to evaluate hedge funds, the Appraisal ratio compares the fund’s alpha to the portfolio’s unsystematic risk (the risk specific to the stock). It compares the return of the manager’s stock picks to the specific risk of those selections. Designed to measure the fund manager’s ability at selecting stocks, the higher the Appraisal ratio, the better the performance of the manager.
The Compound Annual Growth Rate (CAGR) is the average annual growth rate of an investment over a specific period of time. With evidence showing that investments typically do not grow at a steady, constant rate, the CAGR smooths out returns by assuming constant growth. Therefore, the CAGR does not depict the actual real return. Instead it is a rate at which an investment could have grown if it were to grow at a steady rate, which can be useful to gain a general idea of how a starting value of an investment grows over multiple time periods.
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