Key Takeaways
- A risk-adjusted return measures how much an investment earns for each unit of risk it takes, so different investments can be compared fairly.
- The Sharpe ratio divides excess return by total volatility; above 1 is generally considered good.
- The Sortino ratio counts only downside volatility, and the Calmar ratio compares return with the worst peak-to-trough fall.
- Compare investments over the same period and frequency, net of fees, and use more than one measure.
- Standard ratios flatter private market investments unless returns are first adjusted for smoothing, leverage, fees and losses.
Headline returns are seductive. A double-digit IRR on a private equity fund or a high coupon on a private credit note looks attractive on paper. Two investments can both report 10% a year, and one of them can still be the far better use of capital, because it took much less risk to get there.
Risk-adjusted returns measure that difference. They answer one question: how much return am I earning for each unit of risk I take? For family offices, wealth managers and professional investors comparing funds, managers and asset classes, it is the most useful single lens available, and the one most often skipped.
This guide explains what risk-adjusted returns are, how the three most widely used measures (the Sharpe, Sortino and Calmar ratios) are calculated, and how to use them to compare investments, with worked examples throughout.
What are risk-adjusted returns?
A risk-adjusted return expresses an investment's performance relative to the risk taken to achieve it. Instead of looking at return alone, it divides return by a measure of risk, giving a figure that can be compared across investments with very different profiles.
The measures differ in how they define risk:
- Total volatility: how much returns swing around their average, up and down. Used by the Sharpe ratio.
- Downside volatility: only the swings below a target or minimum return. Used by the Sortino ratio.
- Maximum drawdown: the largest peak-to-trough fall in value over a period. Used by the Calmar ratio.
- Market sensitivity (beta): how much an investment moves with the wider market. Used by the Treynor ratio and Jensen's alpha.
Each captures a different kind of pain. Volatility describes a bumpy ride; drawdown describes how far you could fall before recovering. Most investors care about both.
Why headline returns can mislead
Return figures say nothing about how they were produced. A fund can lift its return by using more leverage, lending further down the capital stack, concentrating in one sector or taking on assets that are hard to sell. Each of these raises the return in good years and raises the chance of a large loss in bad ones.
Risk-adjusted measures put those choices on the same scale. A manager who earns 9% with low volatility and shallow drawdowns may be producing more value per unit of risk than one who earns 12% by stretching. The second manager's investors are being paid more, and also being asked to carry more.
A worked example: two funds
To make the ratios concrete, consider two hypothetical funds over the same three-year period. Assume a risk-free rate of 4% a year.
| Measure | Fund A (income) | Fund B (growth) |
|---|---|---|
| Annual return | 9% | 12% |
| Volatility (standard deviation) | 6% | 14% |
| Downside deviation | 3% | 10% |
| Maximum drawdown | 8% | 25% |
Fund B has the higher return. The question is whether it has earned it.
The Sharpe ratio
Developed by the economist William Sharpe in 1966, the Sharpe ratio is the most widely used risk-adjusted measure. It shows how much return an investment earns above the risk-free rate for each unit of total volatility.
Sharpe ratio = (Return − Risk-free rate) ÷ Standard deviation of returns
- Fund A: (9% − 4%) ÷ 6% = 0.83
- Fund B: (12% − 4%) ÷ 14% = 0.57
Fund A delivers more excess return per unit of volatility. As a rule of thumb, a Sharpe ratio above 1 is considered good, above 2 very good, and below 0.5 weak, though acceptable levels vary by asset class and market conditions.
The Sharpe ratio has two known weaknesses. It treats upside volatility as risk, which penalises investments that occasionally jump in value. And it relies on volatility being measured accurately, which is a problem for assets that are valued infrequently.
The Sortino ratio
The Sortino ratio, associated with Frank Sortino, addresses the first weakness by counting only downside volatility: the variation of returns below a target, usually the risk-free rate or zero.
Sortino ratio = (Return − Risk-free rate) ÷ Downside deviation
- Fund A: (9% − 4%) ÷ 3% = 1.67
- Fund B: (12% − 4%) ÷ 10% = 0.80
The gap widens. Most of Fund B's volatility comes from falls rather than rises, so a measure focused on losses judges it more harshly. For income-focused investors and lenders, whose main concern is losing capital, the Sortino ratio is often the more relevant of the two.
The Calmar ratio
The Calmar ratio, introduced by Terry Young in 1991, compares annual return with the largest peak-to-trough loss, usually over 36 months.
Calmar ratio = Annual return ÷ Maximum drawdown
- Fund A: 9% ÷ 8% = 1.13
- Fund B: 12% ÷ 25% = 0.48
This is the measure that speaks most directly to an investor's experience. A 25% drawdown needs a 33% gain to recover. At its normal rate of return, Fund A would recover its worst fall in just under a year; Fund B would need around two and a half years.
Other risk-adjusted measures worth knowing
- Treynor ratio: excess return divided by beta. Useful for a fund held inside a diversified portfolio, where only market risk matters.
- Jensen's alpha: the return above what a fund's beta would predict. A positive alpha suggests skill or a source of return beyond the market.
- Information ratio: return above a benchmark divided by tracking error. Shows how consistently a manager beats its chosen index.
- Return on risk capital: used by lenders and banks, comparing income after expected losses with the capital that could be lost.
How to compare investments on a risk-adjusted basis
The ratios are only as good as the inputs. Before relying on any comparison, check five things.
- Same period: compare over identical dates and, ideally, a full credit or market cycle. A three-year window that misses a downturn flatters everyone.
- Same frequency: monthly and annual data give different results. To annualise a Sharpe ratio built on monthly returns, multiply it by the square root of 12.
- Net of fees: use returns after all management, performance and transaction costs.
- A sensible risk-free rate: use the rate that matches the currency and period of the investment.
- More than one measure: where Sharpe, Sortino and Calmar agree, the conclusion is robust. Where they disagree, the shape of the return distribution is telling you something.
Where the standard ratios fall short
All three ratios assume that the return and risk figures are reliable. In listed markets, with daily prices, that is broadly true. In private markets it often is not. Quarterly valuations smooth out volatility, fund-level leverage hides risk, fees vary widely, and credit losses arrive in clusters rather than evenly.
A private fund can therefore show a Sharpe ratio that looks exceptional for reasons that have little to do with skill. Our companion piece, risk-adjusted returns in private markets, explains how to adjust private market returns for smoothing, leverage, fees, illiquidity and losses before running these comparisons. Part of the extra return private assets offer is the illiquidity premium, and that too should be measured against risk.
What this means for investors
Risk-adjusted returns turn a pile of performance figures into a fair comparison. They reward managers who produce returns efficiently and expose those who rely on leverage, concentration or luck.
For allocators building portfolios across public and private markets, the practical approach is simple. Ask for the volatility, downside deviation and maximum drawdown alongside every return figure. Calculate Sharpe, Sortino and Calmar on consistent data. Treat any private market figure that looks too smooth with suspicion until it has been adjusted. And when two investments offer similar risk-adjusted returns, prefer the one whose protections you understand.
At Kingsbury & Partners, our approach to governance in private credit starts from the same place: the return that matters is the one earned per unit of risk.
Frequently Asked Questions
What is a risk-adjusted return in simple terms?
It is a measure of how much return an investment earns for the amount of risk it takes, allowing investments with different risk levels to be compared fairly.
How do you calculate a risk-adjusted return?
Divide the return, usually in excess of the risk-free rate, by a measure of risk. The Sharpe ratio uses volatility, the Sortino ratio uses downside volatility, and the Calmar ratio uses maximum drawdown.
What is a good Sharpe ratio?
As a rule of thumb, above 1 is good, above 2 is very good and above 3 is excellent. Acceptable levels vary by asset class, period and market conditions.
What is the difference between the Sharpe and Sortino ratios?
The Sharpe ratio counts all volatility as risk, including gains. The Sortino ratio counts only downside volatility, which makes it more relevant for investors focused on avoiding losses.
What is the Calmar ratio used for?
It compares annual return with the largest peak-to-trough loss, typically over three years. It is widely used to assess hedge funds and strategies where the depth of losses matters most.
Is a higher return always better?
No. A higher return earned through more leverage, weaker security or greater concentration may offer less return per unit of risk than a lower, steadier return.
