Going back to the early days of my career before we all had internet in our offices and main frame computers in our laps that provide more free information than we could ever digest rushing out of them like a fire hose, I knew even then that there was much more to managing a portfolio than choosing some good performers and diversifying out the risk. From very early, I searched out analytic tools from places like Morningstar, Lipper, and Value Line. These were sent in monthly or quarterly updates at the time with the stocks and funds they covered. Once we got our own computers and they developed the software (dating myself), we then got to start building portfolios and getting an idea of how they had performed on a longer term basis. This was in the days of looking at 5 & 10 year track records to guide us. The problem is, with the volatility we have seen not only in the markets, but also in the management teams that run these funds, if the manager has only been there a year, then a 5 or 10 year track record is useless. This was the best we had back then, so we worked with it. One of the best measures we used back then was the Sharpe Ratio derived in 1966 by William Sharpe as a way to see how much excess return you are getting for the extra risk you are taking over the risk free rate. The Equation is below:
You can read more about it on Investopedia if you are not familiar. However, from very early on, I always had an issue using Standard Deviation as the sole risk measure because it doesn’t distinguish in any way from positive or negative deviation which is a problem if you are trying to really assess risk. My feelings were, it wasn’t really sharp at all, but back then, that was about all there was and, with limited computing power, more complex formulas were burdensome.
Fast forward to me moving more to tactical management for my clients in the late 1990s (yes, right before the Internet bubble burst which was a blessing and a curse during that time). Once I started moving assets around more often, all of those resources above became less useful since they would only look at portfolios in a static manner. I fell away from using these risk measures as much and lost a piece of my analysis in the process. From then, the returns pretty much became the focus until more recently.
Now there is nothing wrong with focusing on returns, after all, that is the goal in investment portfolios, but when working for clients and managing the bulk of their investment assets, not just a 10% strategy allocation, how you get there can become as important as the final results. All clients want their portfolios to do well over the long term (and short term, in reality), but they also want it to be somewhat comfortable along the way. Higher potential returns do usually come with higher risk, but the clients often underestimate this going in and need to keep some peace of mind to stay the course whatever strategy they choose.
In the ETF portfolio strategy I have been building since introducing the Strength In Numbers report in 2013, I have put a good bit more focus on positioning, rotation, and how these influence the reward to risk profile of the portfolio. This focus and new computing and reporting powers have allowed me to get back to these roots and focus more on building the best possible return with the most advantageous risk profile possible. It is very exciting to track and follow these in real time to help improve my processes. I will have to agree with Barrons in voting Interactive Brokers as the best online custodian with the best reporting for the 4th year in a row. They do an excellent job with their performance reporting and allowing you to add important risk measures like Sharpe Ratio, but they don’t stop there…
One simple report also gives you a whole litany of other useful stats as you can see in the sample below. This is just one example of how a report could be set up via your custodian or add-on software, but it does cover a good bit very concisely.
Here you see not only maximum draw down, peak to valley, recovery, standard deviation, and many other useful stats, but also two new ratios that are right up my alley. The Calmar and Sortino ratios are risk measures like the Sharpe Ratio, but they actually differentiate for upside and downside risk. It takes a little more digging to find information on these than it does to find it on Sharpe, but both are worth the search as I believe they paint a much better picture of the portfolio merits. There are certainly other risk ratios you can use, but these fit well with how I like to look at things.
Sortino Ratio was created in 1983 by Brian M. Rom at the software development company Investment Technologies. The ratio is named for Dr. Frank A. Sortino, an early popularizer of downside risk optimization. Here is the formula:
The above excerpt from the Wikipedia page shows this formula is definitely more complex than Sharpe in order to factor in draw downs. In doing so however, it makes for a much better measure of how much risk is really in a portfolio since none of us really mind the risk of making more money than we expected.
Calmar Ratio (drawdown ratio) is a modified version of the Sterling Ratio which does factor draw downs in to the indicator. For more depth info and formulas for these, click the links above. These ratios were typically calculated on an annual or monthly basis, again due to the time it took to calculate them when created (we take this for granted every day).
Performance and track record is where most of the focus goes in portfolio management side of our business, but we would be well served to spend a little more time on the risk adjustments when analyzing how well a portfolio has really done when measured in a relative fashion with other potential choices. It doesn’t matter if you are reviewing your own performance, that of a potential adviser, or even a subscription service, finding a way to properly measure different strategies based on reward AND risk is the key. As I mentioned in a tweet recently, cautioning to fully understand how those track records are calculated and if they are marked to market or not. Most I have seen are not, which is a bit scary in this day and age. The good news is sites like Marketfy.com are trying to change this as we speak in the subscription space. However, it doesn’t really matter what medium you are reviewing, you want to do your best to cut through the spin and get to the meat of the situations. Viewing things from this perspective can help accomplish this in an effort to provide that confidence we all need to keep moving forward toward our goals.
Good Luck and I hope this helps!