Risk-Adjusted Return

THE IMPORTANCE OF THE
RISK-ADJUSTED RETURN

Risk-Adjusted Return measurements provide investors with information about how much risk – a.k.a., volatility – is accepted to produce an investment's overall return (when compared to the current risk-free rate of return), expressed in numerical format as a ratio of return divided by volatility. Risk-adjusted returns can be calculated for individual securities, stocks, bonds, ETFs, mutual funds, or entire portfolios.

"Risk-Adjusted Return" is the ratio of a portfolio's or investment's units of Performance Attained for each unit of Risk Incurred to produce that performance. 'Units' can be percentages or many other measures.

For example, if, over a 14-year span of a portfolio, it achieves a 2,226% gain – that's great. Every dollar invested at the start would have been turned into $22. Moreover, it's an average return of about 27% per year in an 8%-per-year world.

However, the investor should also consider that during those 14 years, the portfolio declined -85% during its worst selloff. When the risk-free rate of return (e.g., from 10-year Treasury Bonds) is included in the calculation, the portfolio had a risk-adjusted return (Sortino) of 2.70 – compared to the S&P 500, which has a Sortino Rate of 0.64 over the same span.

RISK MEASURES

Two popular measures of return relative to volatility (i.e., 'risk') include the Sharpe Ratio and the Sortino Ratio.

The Sharpe Ratio is the most widely-used measure of risk-adjusted return, perhaps because it was the first measure of risk-adjusted return that was created. The Sharpe Ratio is calculated by using standard deviation and excess returns to determine reward per unit of risk.

For example, if a strategy has an annual return of 30% and the return for risk-free 10-year Treasury bonds is 2.2%, the excess return of that strategy is 27.8%. If the strategy has a Standard Deviation of 22%, the strategy's Sharpe Ratio would be 1.77 (30 ÷ 14 = 1.26).

However, ETFOptimize regularly uses the Sortino Ratio when we are quoting 'Risk-Adjusted Return' figures, with higher numbers being better. The Sortino Ratio is a measure of an investment's or a portfolio's performance relative to its downside volatility only.

Unlike the Sharpe Ratio, which includes all volatility in its calculation, the Sortino ratio does not include upside volatility in its measurement. This is because investors usually consider upside volatility to be 'good' volatility. That is, when an investment shoots sharply higher based on a positive event, there are rarely any complaints from investors. Instead, investors often congratulate themselves for their excellent choice and brag it up to their friends.

Downside volatility is an entirely different story, however, regularly decimating an investor's long-term financial planning. Downside volatility is a loss that must be recovered just to get back to even and is especially damaging when investors capitulate to that loss selling at the low.

Giving it to us straight, “Extreme downside volatility triggers emotional responses that lead you to screw up,” says Russell Kinnel of Morningstar, a leading fund tracking and analysis company.

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Because we are only concerned about downside volatility, we prefer using the Sortino Ratio over the Sharpe ratio, and recommend that conservative investors choose one of our strategies with a higher Sortino Ratio and lower maximum drawdowns.

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Keep in mind that all of the ETFOptimize strategies have exceptionally high Risk-Adjusted Returns – meaning they produce strong annual returns accompanied by low risk – as measured by the strategy's downside volatility (Standard Deviation).

We know how injurious drawdowns can be to a portfolio and place a great deal of attention on minimizing them in each model's quantitative algorithms. By dramatically reducing downside volatility, our strategies can generate consistent growth, year after year, and don't have to make up for losses caused by recessions and bear markets.

A smooth, upward climb of price appreciation – devoid of deep declines or surges of high volatility – helps ensure that an investor will stick with their strategy and thereby, reap its substantial long-term rewards.

The lowest Sortino ratio (lowest risk-adjusted return) of our group of strategies belongs to our Adaptive Equity Rotation (2 ETF) Strategy. The 'Equity-2 Strategy' has an annualized return of 34.62%, a max drawdown of -26.33%, and a Risk-Adjusted Return (Sortino Ratio) of 2.12 since inception. This would mean that it has the 'highest risk' of our strategies.

However, keep in mind that while it has the lowest Sortino ratio of the group, it also has the highest performance of our group of strategies. Also, keep in mind that all of our strategies have very high Risk-Adjusted Returns when compared to alternatives, providing investors with significantly lower risk to accompany their much higher performance.

For example, the strategy we just mentioned as having our lowest Sortino Ratio, i.e., our 'Adaptive Equity Rotation (2 ETF) Strategy still has a Sortino ratio of 2.70 – compared to the S&P 500 ETF (SPY), which has a Sortino ratio of only 0.64 over the same period! 

You can see that our most aggressive and highest-performance strategy still has a risk-adjusted return that's 422% better than the market's Risk-Adjusted Return.

We think you'll agree – that's pretty impressive!

All of the ETFOptimize strategies are designed to provide very steady and robust performance, while also having reduced Drawdowns. Click here to learn about Maximum Drawdowns.

For more information, please see our article about Strategy Selection for additional details about Risk-Adjusted Returns and suggestions on how to choose an ETFOptimize strategy.

For more information on our strategies, please visit the ETFOptimize Investment Strategy Suite!


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