Why you should care about Risk Adjusted Returns?
As investors when we try and make investment decisions it can be easy to focus on the headline figures – What was the final net profit figure for the company? What was the final dividend announced? However as is true with so much about financial markets much of the truth is buried beyond simply the headline figure.
This is perhaps most true when investors make direct comparisons between the headline net return figures of different managed investments. Whilst undoubtedly the final net performance figure of an ETF, MDA strategy or managed fund is an important metric in gauging how that asset has performed it is far from an end to be all means to evaluate how an investment has truly performed. Consider for example the Vanguard Australian Shares Index ETF (VAS) which posted a net total return of 11.84% for the 2017 calendar year. Looking purely at the return side of the equation it’s easy to see how an investor looking to choose an Australian Equity investment would compare this headline figure to the returns of many active managers, seeing Vanguards returns are higher and simply conclude that Vanguard is the better investment. However, it’s important to remember that returns are simply a function of risk i.e. the more risk you take the more return you should expect to receive as compensation. So what kind of risk did VAS need to take in order to earn that 11.84%?
As a passive ETF VAS is mandated to effectively remain 100% invested in equities 100% of the time. This means as an investor you bare the full force of market risk at all times, even in bearish or overvalued market conditions VAS cannot retreat to cash and as an investor you are simply forced to hold equities which are expensive and/or falling in value. So whilst a headline double digit return is attractive and compares favourably to many active managers it is crucial to ask yourself what kind of risk you are taking in order to achieve that return. Risk adjusted returns are one way that an investor can more accurately make direct comparisons between the returns of multiple investments which may have differing levels of equity exposures. This is because risk adjusted returns scale the final net return figure as if the fund manager had remained 100% invested for the entire period. For passive investments this means the total net return figure is almost exactly the same as their risk adjusted total return figure as they are 100% invested at all times.
For investments like the HarbourSide; Australian Growth Strategy there are often big differences between the reported total return figure and the risk adjusted total return figure as the strategy is very rarely 100% invested and often holds substantial amounts of cash when markets do not appear attractive. For example on average over the 2017 calendar year the Australian Growth Strategy was 12.28% invested in cash. This means in order to earn the already market beating net return of 18.4% the strategy only needed equity exposure of 87.72%. Hypothetically if the Australian Growth Strategy had been invested 100% of time (As VAS was) the strategy would have earned a risk adjusted return of 20.97%.
Source - Vanguard