This week, we’re going to step back from market commentary and go back to basic finance: returns, risk, and risk-adjusted return.
- Return is the simplest and most universal concept to understand. You buy US Stock XYZ for $10 and sell it for $12, earning $2 – a 20% return.
- Risk is a little more complex. There are some measures of risk which focus on the probability of losing money in an investment, but risk -- in the classic sense -- is the measure of the volatility of returns for any particular investment. So, an investment which plugs along, increasing by a steady 20% per year is more attractive than an investment which oscillates between earning 40% and 0%. In other words, the more predictable and stable returns are, the lower the risk.
- Finally, there is risk adjusted return. Broadly speaking, investors are willing to adopt greater risk if they are compensated with greater returns. Figuring out the risk-adjusted return helps put investments with different risk metrics on equal footing to see if investors are adequately compensated for the additional risk they are adopting, or avoiding.
The most universal definition for risk adjusted return is “alpha”. Without going into the math, alpha represents the additional, excess return generated by an investment compared to a benchmark. (So, a US stock ABC’s return might be compared to the S&P 500 return.) That excess return is then offset by the relative risk of the investment compared to the risk of the benchmark.
So, to sum up, alpha is a measure of risk-adjusted returns relative to a particular benchmark. Alpha is used by nearly every traditional investment manager and is universally expected when discussing risk. Here’s the problem: plenty of investments don’t compare well to particular benchmarks. Mathematically speaking, the correlation between the return of the investment and the benchmark are low. Sometimes, the correlations are so low, that the modern portfolio theory statistics (alpha, beta, etc.) are essentially meaningless.
For a real world example the correlations between most equity managers and singular investments are usually appropriate. Most US Large Cap Value investment managers have reasonably strong correlations (~95%) to an appropriate index (in this case, the Russell 1000 Value index). However, the classic indices for fixed income managers can be downright misleading when used to calculate alpha and risk adjusted returns for intermediate bond, international bond, or multi-sector bond investment managers. Worse still, alternative investments often defy categorization and, by design, sometimes have no relationship to any benchmark at all.
The takeaway point is this: despite the universal presence of alpha in fund commentaries, fact sheets, and other due-diligence information, it is not always the best measure of risk-adjusted return. Depending on the circumstance, there are alternative measures for risk and return which may be a better fit for truly understanding an investment.