Risk-adjusted returns measure investment performance relative to the risk taken to achieve those returns. A 15% return with 20% volatility may be worse than 10% return with 5% volatility.
Beginner
What It Means
Raw returns don’t tell the whole story. Risk-adjusted returns answer the question: “How much return did I get for each unit of risk I took?” Higher risk-adjusted returns mean more efficient use of risk.
Portfolio Example
| Portfolio | Return | Volatility | Risk-Adjusted? |
|---|
| Portfolio A | 15% | 20% | Lower |
| Portfolio B | 12% | 8% | Higher |
Why It Matters
Comparing raw returns is misleading. A hedge fund returning 20% with 40% volatility isn’t necessarily better than an index fund returning 10% with 15% volatility. Risk-adjusted metrics reveal true performance quality.
Advanced
Key Risk-Adjusted Metrics
| Metric | Formula | Best For |
|---|
| Sharpe Ratio | (Return - Rf) / Volatility | General comparison |
| Sortino Ratio | (Return - Rf) / Downside Dev | Downside-focused |
| Treynor Ratio | (Return - Rf) / Beta | Diversified portfolios |
| Information Ratio | Alpha / Tracking Error | Active managers |
| Calmar Ratio | Return / Max Drawdown | Drawdown-sensitive |
Sharpe Ratio
The most common risk-adjusted measure:
Sharpe Ratio = (Rp - Rf) / σp
Where:
- Rp = Portfolio return
- Rf = Risk-free rate
- σp = Portfolio volatility
| Sharpe | Interpretation |
|---|
| Below 0.5 | Below average |
| 0.5 - 1.0 | Good |
| 1.0 - 1.5 | Very good |
| Above 1.5 | Excellent (rare) |
Sortino Ratio
Focuses only on downside risk:
Sortino Ratio = (Rp - Rf) / Downside Deviation
Downside Deviation = Only negative returns count
Sortino is often preferred because investors don’t mind upside volatility - only downside hurts. A stock that jumps 10% isn’t “risky” in any meaningful sense.
Calmar Ratio
Uses maximum drawdown as the risk measure:
Calmar Ratio = Annual Return / |Maximum Drawdown|
| Calmar | Interpretation |
|---|
| Below 0.5 | Poor |
| 0.5 - 1.0 | Acceptable |
| 1.0 - 2.0 | Good |
| Above 2.0 | Excellent |
Comparing Metrics
| Metric | Risk Measure | Strengths | Weaknesses |
|---|
| Sharpe | Total volatility | Simple, universal | Penalizes upside |
| Sortino | Downside only | More intuitive | Fewer data points |
| Calmar | Max drawdown | Captures tail risk | Single worst event |
| Information | Tracking error | Active management focus | Benchmark dependent |
Practical Application
When to use each metric:
- Sharpe: Comparing any strategies against each other
- Sortino: When you care specifically about losses
- Calmar: When drawdowns are your primary concern
- Information Ratio: Evaluating active managers vs. benchmark
- Treynor: Comparing well-diversified portfolios
Limitations
- Backward-Looking: Past risk-adjusted returns don’t guarantee future performance
- Distribution Assumptions: Most assume normal returns (reality has fat tails)
- Time Period Sensitive: Results vary significantly by measurement period
- Gaming: Some strategies artificially inflate ratios (selling options, smoothing)
A high Sharpe Ratio from selling options or illiquid strategies may mask hidden tail risks. Always understand the source of risk-adjusted returns.
