In times of ongoing high market volatility and crisis, investors and portfolio managers face the challenging task of assessing investment-related risks and possible returns. The timing could not be more appropriate for us to share with you what portfolio risk indicators to watch for to target the most stable and predictable return on your portfolio.
Many investors use the return on investment (ROI) as the main criteria for choosing the investment product to spend the money on. They compare the return on stocks vs. return on bonds, returns on large caps vs return on small caps companies, examine companies’ analytical reports to identify the ones with the most growth potential, and sometimes even browse through social network ads promising tens of thousands of percent of return on some crypto assets. However, it is not only high ROI that makes for a smart investment but also an investment product’s ability to deliver stable returns over a period.
We would like to elaborate on a few, fundamental and easy-to-comprehend risk assessment indicators: standard deviation, downside deviation, Sharpe ratio, and Sortino ratio. Examining these risk assessment metrics along with a visual portfolio track record even inexperienced investors can get a clue when something is amiss with the portfolio performance.
We will start with the standard deviation. Portfolio standard deviation refers to the volatility of the portfolio that factors in the standard deviation of each of the assets allocated in the total portfolio, the respective weight of each asset in the total portfolio, and the correlation between each pair of assets of the portfolio. To put it simply, it tells investors how much the investment return will deviate from its expected return.
The indicator of portfolio standard deviation on its own is not informative. It becomes informative only when compared to other benchmark indicators such as S&P standard deviation, a portfolio strategy standard deviation, or the standard deviation of any other benchmark used by an investor. You can get an idea of how well a portfolio manager is doing his job of controlling risks by considering the standard deviation of the managed portfolio over a certain period, for example, several months.
Thus, if you compare your portfolio standard deviation on a month-to-month basis, and see that in one month your portfolio standard deviation was 2%, the second month it was 4%, the month after 1%, and marked 5% in the fourth month, this could mean the following things:
- either allocation of some securities in your portfolio or the whole portfolio allocation approach does not factor in keeping risks associated with the strategy and the actual strategy returns vs. expected returns under control.
- the portfolio manager makes random portfolio allocations on the market bearing incommensurable risks over various months.
Neither of mentioned above is good. Such random allocations by the portfolio manager may inflict more risk on the portfolio when the market is already in decline.
Let us assume, for example, that in the preceding month your portfolio standard deviation ratio equaled 2 and its volatility level was quite comfortable. In the following month, your portfolio manager decides to take a lot more risk, whereas the market plunges sharply. Then you may find yourself in a situation where your portfolio standard deviation increases by two or three times, making the drawdowns of negative returns bigger than the declining market. This can create a situation where investors’ intra-trading losses may become so significant that it would be difficult to recover them afterward.
Assessing risk metrics against each other
Keeping portfolio risks under control aims at cutting the tails and preventing the occurrence of big, outsized losses by monitoring portfolio performance and tracking its exposure to technical risks on a consistent, at least a month-to-month basis. Consequently, applying standard deviation as one of the key risk assessment metrics should always be done in comparison with downside deviation, which is a measure of downside risk that focuses on returns that fall below a minimum threshold or minimum acceptable return (MAR).
Consider a couple of scenarios:
- The work of the portfolio manager can be viewed as good if the standard deviation of a portfolio is high while the deviation for the most part is directed upward. This means that the profit-taking potential of positions maintained by the portfolio manager varies. He may close some positions in highly volatile stocks after taking a profit of 50%, 100%, or 150; or he may close positions in low-volatility stocks earning only minimum required return.
- On the other hand, let us assume that monitoring of tails and downside deviation is done in a simultaneous and moving fashion with downside deviation indicating just a slight error from month -to month, and standard deviation exceeding downside deviation by two or three times. This scenario does not necessarily mean that a portfolio manager’s performance is inefficient. Rather, it emphasizes the manager’s focus on risk management and keeping possible negative consequences and losses under control as opposed to the approach of maximizing profits at any cost. That in itself is not at all a bad approach.
Bringing Sharpe and Sortino in a risk assessment equation
Sharpe and Sortino indicators – Both indicate portfolio return based on an aggregate return applied to standard deviation and downside deviation. The Sortino ratio helps measure the risk-adjusted return of an investment. Both the Sortino ratio and the Sharpe ratio determine an investment’s return through risk-adjusted methods. However, the Sortino ratio only factors in downside volatility. Although not perfect, comparing Sharpe and Sortino ratios of a portfolio under management to their values in benchmark indicators such as S&P, Nasdaq, and bonds’ index serves as quite accurate reference points for a portfolio’s risk assessment.
If the standard deviation of an investment portfolio’s return is small and stable but it is significantly below the market return, an investor certainly wants to know if his portfolio manager is generating some alpha. Does the portfolio manager manage the assets efficiently, given that the return on portfolio strategy is below the benchmark indexes even though the associated risks are quite low? Could it be that the portfolio manager simply allocates less funding to bear fewer risks while maintaining a mediocre and inefficient selection of securities in a portfolio?
Comparing the Sharpe ratio of your portfolio to the S&P benchmark Sharpe ratio is the first evident indicator of the portfolio manager’s efficiency in managing your portfolio. The key trait to look for is whether the Sharpe ratio of your portfolio exceeds the benchmark indicator Sharpe ratio. As such, the higher the value of the Sharpe ratio, in particular exceeding 1,5, the better it is, especially in times of market drawdowns.
The Sortino ratio is also important. We can compare the Sortino ratio of an investor’s portfolio and its benchmark indicator. Of particular interest is the comparison of Sharpe and Sortino ratios within a single portfolio on their own, which provides an informative insight into the efficiency of your portfolio manager’s work.
Can your portfolio manager keep the level of critical drawdowns and tails to a minimum, while generating a stable and predictable return? Thus, with the Sharpe ratio fluctuating from 1,5-2, the Sortino ratio can reach 10 or 11. Values 10 and 11 mean that your portfolio manager utilizes all resources to generate the return available on the market meanwhile applying a systematic and rigid approach to controlling portfolio risks.
Look at your portfolio performance indicators and compare them to each other. Are they better or worse than the benchmark indicators? You can even compare these ratios for the ETF market overall, compare all these ratios across your actively managed portfolio, or within particular benchmarks.
Compare Sharpe and Sortino to each other. Although these metrics are not a perfect measurement of the efficiency of your portfolio manager’s work and cannot serve as infallible indicators of whether your manager generates sufficient market-neutral alpha, let alone operational aspects of risk management, nevertheless, paying attention to these four basic, simple indicators can point an investor in the right direction. Is the portfolio performance on the right track or does it perform contrary to your and your portfolio manager’s expectations raising the risks and exceeding market losses, - these are the questions that the four indicators can help clarify.
© Sigma Global Management
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