Quantitative Analysis · Data Science · Machine Learning

Evaluating a portfolio’s risk-adjusted return is more informative than evaluating its return alone because it allows investors to compare the true performance of different portfolios and make more informed investment decisions by measuring the return over the risk taken. In other words, it allows investors to compare the performance of different portfolios on a level playing field.

Without adjusting for risk, a portfolio with a higher return may seem more attractive than one with a lower return, but the higher return could be due to the portfolio taking on more risk. By adjusting for risk, investors can better compare the true performance of different portfolios and make more informed investment decisions.

By evaluating a portfolio’s risk-adjusted return, investors can identify portfolios that are generating returns that are commensurate with the level of risk they are taking on. A portfolio that is generating a high return but taking on a lot of risk may not be as attractive as one that is generating a lower return but with less risk.

Various methods exist to measure a portfolio or hedge fund’s risk-adjusted returns.  Below is an overview of each of the most common risk-adjusted evaluations of return on investment for a portfolio or hedge fund:

• Sharpe Ratio: measures the risk-adjusted return of a portfolio by subtracting the risk-free rate of return from the portfolio’s return and then dividing that value by the portfolio’s standard deviation.
• Sortino Ratio: similar to the Sharpe ratio, but uses the downside deviation instead of the standard deviation to measure risk.
• Treynor Ratio: measures the risk-adjusted return of a portfolio by dividing the portfolio’s excess return by its beta.
• Jensen’s Alpha: measures the return on a portfolio that is in excess of the return predicted by the capital asset pricing model (CAPM).
• Information Ratio: measures the risk-adjusted return of a portfolio by subtracting the benchmark return from the portfolio’s return and then dividing that value by the portfolio’s tracking error.
• Gain-to-Pain Ratio: measures the risk-adjusted return of a portfolio by dividing the total return by the maximum drawdown.
• Omega Ratio: measures the risk-adjusted return of a portfolio by comparing the probability of the portfolio generating a return greater than a certain target return to the probability of the portfolio generating a return less than that target return.
• M-Squared Ratio: measures the risk-adjusted return of a portfolio by comparing the portfolio’s return to the return of a benchmark portfolio over a certain time period.
• Calmar Ratio: measures the risk-adjusted return of a portfolio by dividing the portfolio’s return by the maximum drawdown over a certain time period.
• Sterling Ratio: measures the risk-adjusted return of a portfolio by dividing the portfolio’s excess return by the maximum drawdown.

These are just a few examples of risk-adjusted return metrics available, and there are many other methods for evaluating portfolio risk-adjusted returns. Each of these metrics has its own strengths and weaknesses and it’s important to consider which metric best aligns with your investment goals and risk tolerance.