The Share Centre | Understanding Investment Measures

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Understanding Investment Measures

When you buy a fund you are really buying into a manager or investment process which you hope will deliver returns in excess of the benchmark or other appropriate watermark. 

When you make your investment decision you need confidence that over the long term, three to five years, your chosen manager can beat the benchmark and consistently outperform his/her peers. The data that can help you is historical and cannot guarantee outperformance in the future.

Investment is simply a risk and reward trade off. The ‘Holy Grail’ would be no risk and big rewards, but achieving that is almost impossible. We therefore seek managers who can outperform consistently with relative low risk compared to peers and the benchmark.

Measures which are associated with risk and reward are described below.

Alpha

A measure of a performance compared to its benchmark. It represents the return of the fund when the benchmark is assumed to have a return of zero, and indicates the extra value generated by the manager’s activities. If alpha is 5, the fund has outperformed its benchmark by 5%, and the greater the alpha, the greater the outperformance.

Beta

A statistical estimate of a fund’s volatility compared to its benchmark. A fund with a beta close to 1 will generally move in line with the benchmark. Higher than 1 and the fund is more volatile than the benchmark, so that, for example, a beta of 1.5 suggests a fund should rise or fall 1.5 points for every 1 point of benchmark movement. 

While a high beta is an advantage in a rising market, the converse is the case when falls are expected. In such an environment, managers will look for betas below 1. It is important to stress that beta is just an estimate.

Sharpe

A commonly-used measure which calculates the level of a fund’s return over and above the return of a notional risk-free investment, such as cash or government bonds. The difference in returns is divided by the fund’s standard deviation – its volatility, or risk measurement. The resulting ratio is an indication of the amount of excess return generated per unit of risk. 

Sharpe is useful when comparing similar portfolios or instruments. There is no absolute definition of a ‘good’ or  a ‘bad’ Sharpe ratio, although the higher the Sharpe ratio the better, and a fund with a negative Sharpe would be better off investing in risk-free government securities.  When two funds have achieved a similar return, bear in mind that the one with the higher Sharpe ratio took lower risk.

R-Squared

The R-Squared measure is an indication of how closely correlated a fund is to an index or a benchmark. It can be treated as a percentage, showing what proportion of a fund's movements can be attributed to those of the benchmark. Values for R-Squared range between 0 and 1, with 0 indicating no correlation at all, and 1, rarely, showing a perfect match. Values upwards of 0.7 suggest that the fund's behaviour is increasingly closely linked to its benchmark, whereas the relevance diminishes as R-Squared descends towards 0.5, and starts to disappear altogether below that.

R-Squared is a key ratio, in that other measures of a fund's performance - such as Alpha and Beta - will have been calculated by reference to its benchmark. The weaker the R-Squared correlation, the more unsuitable the benchmark is, and the more unreliable these measures will be in assessing the fund.

Information ratio

Assesses the degree to which a manager uses skill and knowledge to enhance returns, and is a versatile and useful risk-adjusted measure of actively-managed fund performance. The ratio provides a value for risk taken by the manager which was greater than the risk delivered by the market.

It is generally considered that a figure of 0.5 reflects a good performance, 0.75 very good, and 1.00 outstanding. This measure is particularly useful when comparing a group of funds with similar management styles and asset allocation policies. If two funds have near-identical alphas, the higher information ratio identifies the manager who has been more skilful in identifying stock-picks that deviated from the benchmark or index, while the lower denotes gains that have more to do with market movements than active management. 

Volatility

Standard deviation is a statistical measurement which, when applied to an investment fund, expresses its volatility, or risk. It shows how widely a range of returns varied from the fund’s average return over a particular period. Low volatility reduces the risk of buying into an investment in the upper range of its deviation cycle. For example, if a fund had an average return of 5%, and its volatility was 15, this would mean that the range of its returns over the period had swung between +20% and -10%. Another fund with the same average return and volatility of 5 would return between 10% and nothing, but there would at least be no loss. 

While volatility is specific to a fund’s particular mix of investments, comparison to other portfolios is difficult, and for those that offer similar returns the lower-volatility funds are preferable. There is no point in taking on higher risk in order to achieve the same reward. 

All of these measures can be found in the fact sheets of each fund on our website. 

Definitions have been provided by Financial Express.