Other metrics of value for consideration include: Sharpe Ratio, Treynor Ratio, Sterling Ratio, cumulative rate of return, alpha, beta, R-square, maximum drawdown, up and down market capture, overlap analysis (i.e. the same position is held in multiple accounts/funds), equity and fixed income properties. These metrics will help you and the client better understand the true performance of the portfolio and the constituent parts of the portfolio.
The lower boundary of acceptable risk (the investors risk tolerance) is determined by first calculating the historical mean or annualized rate of return and standard deviation of the portfolio. Using that information we can easily determine the upper and lower boundaries of return at any specified probability level. In most cases we use the 90% probability value.
At the 90% level:
Upper boundary = 1.654 * STD + Mean ROR
Lower boundary = 1.654 * STD – Mean ROR
This simply means that, all things being equal (i.e. our historical or forecasted return and standard deviation values are reasonably accurate) there is a 5% chance the boundaries could be exceeded. Obviously, the more accurate your assumptions are the more accurate the downside risk parameter will be as well. In any case, it gives you and the investor a basis for understanding how much risk might be involved and decision making.
The risk (volatility) of a portfolio is directly related to the correlation characteristics of the assets and the portfolio. The lower the asset standard deviations and the greater the degree of negative correlation, the lower the portfolio risk will be.
Metrics indicating that the current portfolio exhibits excessive risk and is underperforming:
- Downside risk/Lower Boundary is greater than established in the investor’s Risk Profile indicates that the portfolio is too risky.
- Maximum Drawdown is high indicating excessive volatility.
- Sharpe Ratio is low (under 0.80) indicates that the portfolio is very inefficient (poor asset allocation).
- Correlations are low indicating poor asset/security selection.
Rates of return or standard deviations alone will not tell you if a portfolio is too volatile or underperforming. An asset with a higher standard deviation may not indicate greater volatility since a higher rate of return may show that there is greater incremental return per unit of change in standard deviation. It is important to consistently consider several metrics you feel are important when reviewing the risk/return characteristics of the portfolio and its relationship to the investor’s Risk Profile.
The Equity and Fixed Income Properties are always important in the analysis. Fixed Income Properties such as average duration, yield and rating are very important in understanding the balance and performance of the investment portfolio.