| Risk-adjusted return provides a simple means of | | | | To produce a number that is intuitive and significant to |
| comparing similar mutual funds on a common basis. As | | | | the average investor, actual average return should be |
| similar mutual funds usually are not equivalent in terms | | | | divided by the standard deviation of actual returns and |
| of risk, simply comparing their average returns is not a | | | | the result then multiplied by the standard deviation of |
| valid means of selecting the best mutual fund. | | | | the actual returns of a relevant index for the same |
| Similar mutual funds are those that are in the same | | | | period of time. (A broad market index can be used in |
| category or asset class. In other words, compare large | | | | lieu of an index that is representative of the category |
| cap value to large cap value, technology to technology, | | | | but the result will be less relevant.) The result is a |
| emerging markets to emerging markets and so on. It's | | | | risk-adjusted return that is derived from and relates |
| important to understand that using risk-adjusted returns | | | | directly to published returns and is thus a more intuitive |
| to compare mutual funds in different categories may | | | | measure for the average investor. A mutual fund's |
| be interesting, and useful in getting a feel for the | | | | risk-adjusted return is what a fund would have |
| relative risk of different asset classes, but it's not a | | | | returned if its level of risk, as measured by the |
| valid means of selecting mutual funds, as mutual funds | | | | standard deviation of returns, was the same as that of |
| in different asset classes are not alternative | | | | the benchmark index. |
| investments, they are complementary investments in a | | | | Not much is lost by computing risk-adjusted returns in |
| well-diversified portfolio. | | | | this manner and the result is much more useful to the |
| The Sharpe ratio has long been used as a | | | | general public. What is lost is the measure of excess |
| risk-to-return performance measure. The Sharpe ratio | | | | returns, but that isn't the objective of computing |
| is computed by dividing the average excess return by | | | | risk-adjusted returns. Rather, the objective is to |
| the standard deviation of excess returns, where | | | | compare mutual funds on a relative basis in terms that |
| excess return is the actual return less the average | | | | are meaningful to the average investor. As long as the |
| T-Bill rate for the same period. The result is a measure | | | | funds that are being compared are similar in nature |
| of excess return per unit of risk. This is a very | | | | and their returns cover the same period of time, using |
| significant and useful statistic but it is not particularly | | | | the risk-adjusted return for comparing mutual funds is |
| intuitive to the average investor, who is accustomed to | | | | reasonably reliable basis for selection that will lead you |
| thinking in terms of actual returns. The Sharpe ratio is | | | | to the same selection as the Sharpe ratio more often |
| the best purely quantitative measure for comparing | | | | than not. However, as the possibility of a sub-optimal |
| mutual funds, but for most investors, comparing | | | | selection exists, it's best to use go one more step with |
| risk-adjusted returns is a necessary step in the | | | | the quantitative analysis. |
| process, as it makes the comparison in terms with | | | | The final quantitative step in the comparison should be |
| which they are familiar. | | | | the use of the Sharpe ratio, which is an absolute |
| Modigliani and Modigliani recognized that average | | | | measure of risk-to-return that is widely published and |
| investors did not find the Sharpe ratio intuitive and | | | | therefore doesn't need to be calculated. The fund with |
| addressed this shortcoming by multiplying the Sharpe | | | | the highest Sharpe ratio should be selected and usually |
| ratio by the standard deviation of the excess returns | | | | this will be the fund with the highest risk-adjusted |
| on a broad market index, such as the S&P 500 or | | | | return. Mathematically, computing the risk-adjusted |
| the Wilshire 5000, for the same time period. This yields | | | | return from actual returns is not as reliable for |
| the risk-adjusted excess return. This, too, is a significant | | | | identifying the best mutual fund but it's not as abstract |
| and useful statistic, as it measures the return in excess | | | | as the Sharpe ratio. |
| of the risk-free rate, which is the basis from which all | | | | Using risk-adjusted returns to gain an understanding of |
| risky investments should be measured. However, this | | | | the relative performance of mutual funds then |
| still falls a bit short of being truly intuitive to the average | | | | validating the comparison with the Sharpe ratio is a |
| investor, and excess returns are not part of the mutual | | | | good strategy for the average investor for comparing |
| fund data that is ordinarily published. | | | | mutual funds. |