An Intro to Sharpe and Information Ratios CHART OF THE WEEK SEPTEMBER 4, 2012 In this post-great Recession/Financial Crisis environment in which investment risk awareness has been heightened, return expectations have been lowered, and market forces are making it difficult for investment professionals to achieve much return differentiation it s become increasingly important to use and understand sophisticated relative performance measurements ( metrics ) for investment portfolios. Sharpe Ratios and Information Ratios are two widely used performance metrics that we ll define, compare, and contrast in this piece. Increased Emphasis on Risk-Adjusted Returns First, though, a little background. Under current conditions, we ve seen an increased emphasis on risk-adjusted returns. That means not just measuring the return of an investment over time, but also assessing the amount of risk that was used to achieve it, and its long-term impact. The reason for this emphasis: Additional risk exposure can lead to increased volatility, both on the upside (which is typically why the risk was added) and the downside (when the price for the added risk typically gets paid). Achieving more consistent returns and reduced return volatility are among the top objectives of a risk-adjusted return approach to portfolio management. To measure return volatility, investment managers often use standard deviation, which is a statistical measurement of variations from the average return. More volatility means a higher standard deviation. One of the goals of a risk-adjusted approach is to lower the standard deviation of returns. It s become increasingly important to use and understand sophisticated relative performance measurements ( metrics ) for investment portfolios. Sharpe Ratios and Information Ratios are two widely used performance metrics. Other Risk Measures Portfolio risk can be assessed in several other ways. One is beta, which is the amount of market risk exposure a portfolio has, where the market is defined by a benchmark index. Another is alpha how much the portfolio has outperformed or underperformed the benchmark due to active management when both the portfolio and the benchmark are compared on an equal basis of beta exposure. These risk measures serve as important background for discussing the characteristics of passive investment management strategies (designed to mimic a benchmark index and minimize trading costs) and active strategies (which take active investment positions that differ from the benchmark s, with the objective of achieving positive alpha capturing more of the market s upswings than downswings and beating the benchmark). (It s important to note that passive strategy returns rarely equal benchmark performance exactly. That s because of trading costs, and because passively managed portfolios often don t own every security in the benchmarks. Instead, passive managers try to reduce trading costs by holding only benchmark securities that tend to track the benchmark s overall performance.) Non-FDIC Insured May Lose Value No Bank Guarantee
The Sharpe Ratio s Simplicity Our digressions into risk-adjusted returns, risk measures, standard deviation, and passive versus active management were necessary because Sharpe and Information Ratio discussions rely on those concepts. For example, risk-adjusted returns and standard deviation help form the foundation for the Sharpe Ratio, developed by Nobel Laureate William F. Sharpe in the 1960s. The Sharpe Ratio is a simple but useful risk-adjusted measure of returns, showing the amount of return (reward) earned per unit of risk from any asset with a risk component. More specifically, the Sharpe Ratio shows how much excess return (portfolio return minus the return of a relatively low-risk asset, such as a U.S. Treasury bill, over a given period of time) is received per unit of risk. Risk, in the Sharp Ratio s case, is shown as the standard deviation of the portfolio s excess returns over that same time period (for the formula, see the comparison table at the end of this piece). The higher the Sharpe Ratio, the better, theoretically, the portfolio s risk-adjusted performance portfolios with higher Sharpe Ratios tend to provide more return for the same amount of risk. A negative Sharpe Ratio would indicate the portfolio s return was less than that of the relatively low-risk asset (such as a U.S. Treasury bill) in the excess return calculation. The Sharpe Ratio helps facilitate useful portfolio comparisons by adjusting for risk. For example, if the manager of a hypothetical Fund A generated an annualized return of 10% over three years while the manager of a hypothetical Fund B generated an annualized return of 8% over the same period, it would appear that Fund A is better managed than Fund B. However, if the Fund A manager took much larger risks than the Fund B manager and those risks are reflected in a higher standard deviation of returns for Fund A, then Fund B may have the higher Sharpe Ratio and the better risk-adjusted returns (with Fund A facing potentially more downside risk under less favorable return conditions). As the use of sector benchmarks for active managers became more widespread, active managers demanded more sophisticated tools to measure active management. What was needed was essentially a Sharpe Ratio to compare active managers. One answer turned out to be the Information Ratio (IR). IR Basically a More-Focused Sharpe Ratio for Active Managers The Sharpe Ratio is useful, but not perfect. It can be skewed by irregular return factors that can upset the standard deviation calculation, and it doesn t take into account the market risk (beta) exposure of the portfolio. Also, it was the product of a simpler time in investment management history, before sector specialization and the benchmarking of returns became prevalent. As the use of sector benchmarks for active managers became more widespread, active managers (and the industry analysts who evaluate them) demanded more sophisticated tools to measure active management. Beating the benchmark is only half the story; the other half is how much risk was taken to achieve this outperformance. What was needed was essentially a Sharpe Ratio to compare active managers. One answer turned out to be the Information Ratio (IR). If we replace the Sharpe Ratio s excess return in the numerator with a portfolio s active return (the average annualized return of an actively managed portfolio minus the average annualized return of the portfolio s benchmark over a given period, adjusted for the portfolio s beta exposure), and you replace the Sharpe Ratio s standard deviation of excess returns in the denominator with the standard deviation of a portfolio s active returns over the period, you have the IR (for its formula, see the comparison table at the end of this piece). 2
The IR is more focused than the Sharpe Ratio. While the Sharpe Ratio expresses the amount of overall excess return (market-driven + active management-driven) per unit of overall risk, the IR computes only the active management-driven (alpha) returns per unit of alpha-driven risk. And while the Sharpe Ratio s excess returns are consistently calculated with regard to a relatively low-risk benchmark such as a U.S. Treasury bill, the IR s active returns are calculated with regard to each portfolio s specific market benchmark. Outlining Other IR Features Why is IR called Information Ratio? We believe information management helps differentiate between more and less successful managers. More successful managers tend to have better abilities to gather and process available information that can help them provide superior security selection and/or more insightful economic, market, and sector analysis for their clients. Other IR information: The standard deviation of active returns in the IR s denominator is called tracking error. It s always a positive number. IRs can be positive or negative because the active return in the numerator can be positive or negative. A positive IR is preferred over a negative IR as with the Sharpe Ratio, the higher the IR, the better. The IR should be measured over a meaningful period of time, typically at least three to five years. Like the Sharpe Ratio, the IR is not perfect it can be influenced by external factors such as changes in market volatility. Tracking error will tend to increase in volatile markets for even the best active managers. While the Sharpe Ratio is still widely used for risk-adjusted portfolio comparisons in the investment management industry, for actively managed portfolios, the IR is considered the best risk-adjusted measure of comparative performance. In conclusion, we offer the following table, which shows the similarities and differences between the Sharpe Ratio and IR: Name Formula Comments Sharpe Ratio Information Ratio Excess Return (Portfolio Return Treasury Bill Return) Standard Deviation of Excess Returns Active Return (Portfolio Return Adj. Benchmark Return) Standard Deviation of Active Returns Measures overall risk-adjusted return The most widely used metric of risk-adjusted returns Does not take into account the market risk (beta) exposure of the portfolio Measures active risk-adjusted return Benchmark return is adjusted to the market risk (beta) of the portfolio Denominator is called Tracking Error While the Sharpe Ratio is still widely used for risk-adjusted portfolio comparisons in the investment management industry, for actively managed portfolios, the IR is considered the best risk-adjusted measure of comparative performance. 3
Glossary Active investment management Active investment management strategies are the opposite of passive investment strategies (defined below). Active portfolio managers regularly take investment positions that clearly differ from those of the portfolio s performance benchmark, with the objective of outperforming the benchmark over time. In addition to the upside potential of outperforming the benchmark, there s also the downside possibility of underperforming the benchmark. In an efficient market, there should be roughly the same magnitude of outperformers and underperformers for any given benchmark. Excess return Excess return, in investment management literature, is used in risk-adjusted return (defined below) discussions and risk-adjusted return calculations, such as the Sharpe Ratio (defined below). It equals the return of a portfolio minus the return of what is considered to be a relatively risk-free asset, such as a U.S. Treasury bill. Information Ratio (IR) IR is a risk-adjusted return (defined below) measure for comparing the performance of active investment managers (defined above) over time. Its purpose is to help determine how much return an active manager has added per unit of active management risk. Think of IR as a Sharpe Ratio (defined below) for active investment management; the IR is more focused than the Sharpe Ratio. Starting with the Sharpe Ratio s formula, if we replace the excess return (defined above) in the numerator with a portfolio s active return (the average annualized return of an actively managed portfolio minus the average annualized return of the portfolio s benchmark over a given period, adjusted for the portfolio s market risk exposure), and you replace the Sharpe Ratio s standard deviation (defined below) of excess returns in the denominator with the standard deviation of a portfolio s active returns over the period, you have the IR. While the Sharpe Ratio expresses the amount of excess return per unit of overall risk, the IR computes only the active management-driven (alpha) returns per unit of alpha-driven risk. And while the Sharpe Ratio s excess returns are calculated with regard to what is considered to be a relatively risk-free asset, such as a U.S. Treasury bill, the IR s active returns are calculated with regard to each portfolio s specific market benchmark. The higher the IR, the better. The IR should be measured over a meaningful period of time, typically at least three to five years. The IR is not perfect it can be influenced by external factors such as changes in market volatility. The standard deviation of active returns in the IR s denominator is called tracking error (defined below).tracking error will tend to increase in volatile markets for even the best active managers. Passive investment management Passive investment management strategies are the opposite of active investment strategies (defined above). Passive strategies are based on the philosophy that it s difficult for portfolio managers and investors to outperform the financial markets over time, especially since managers and investors are saddled with trading and other investment management costs. So passive strategies are designed to mimic market benchmark indices and minimize trading costs. It s important to note, however, that passive strategy returns rarely equal benchmark performance exactly. That s because trading costs are still involved, and because passively managed portfolios often don t own every security in the benchmarks. Instead, passive managers try to reduce trading costs by holding only benchmark securities that tend to track the benchmark s overall performance. 4
Risk-adjusted returns Risk-adjusted returns, in financial literature, are investment returns that are not just measured for their absolute magnitude over time. They are also measured for the amount of risk that was used to achieve them, and the potential impact of that risk on returns over time. The philosophy behind measuring risk-adjusted returns is to better understand and predict both upside potential and downside risk from investments based on the amount of risk that is used to achieve their returns. Sharpe Ratio Developed by Nobel Laureate William F. Sharpe in the 1960s, the Sharpe Ratio is a simple but useful risk-adjusted measure of returns, showing the amount of return (reward) earned per unit of risk from any asset with a risk component. More specifically, the Sharpe Ratio shows how much excess return (portfolio return minus the return of what is considered to be a relatively low-risk asset, such as a U.S. Treasury bill, over a given period of time) is received per unit of risk over that same time period. Risk, in the Sharp Ratio s case, is shown as the standard deviation (defined below) of the portfolio s excess returns over that same time period. The higher the Sharpe Ratio, the better, theoretically, the portfolio s risk-adjusted performance portfolios with higher Sharpe Ratios tend to provide more return for the same amount of risk. The Sharpe Ratio is useful, but not perfect. It can be skewed by irregular return factors that can upset the standard deviation calculation, and it doesn t take into account the market risk (beta) exposure of the portfolio. Also, it was the product of a simpler time in investment management history, before sector specialization and the benchmarking of returns became prevalent. Visit americancenturyblog.com to read the Chart of the Week and other economic, market and investment insights from the experts at American Century Investments. Standard deviation Standard deviation is a statistical measurement of variations from the average. In financial literature, it s often used to measure risk, when risk is measured or defined in terms of volatility. In general, more risk means more volatility, and more volatility means a higher standard deviation there s more variation from the average of the data being measured. In this context, reducing risk means seeking lower standard deviation. Tracking error Tracking error measures how much the return of an investment portfolio deviates from the return of its benchmark index. For example, an index fund (a mutual fund that s managed to closely match the performance of a particular index) should have a tracking error close to zero, while an actively managed portfolio (where the goal is outperforming the benchmark rather than simply tracking it) would typically have a higher tracking error, which can be potentially positive or negative. The opinions expressed are those of our investment professionals, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only. 5 IN-FLY-76052 1209 2012 American Century Proprietary Holdings, Inc. All rights reserved. Non-FDIC Insured May Lose Value No Bank Guarantee