What are Risk-Adjusted Returns?

Introduction

In the world of investing, it’s easy to focus on the headline figures—those impressive returns that promise significant profits. However, not all returns are created equal. To truly understand how well an investment is performing, it is essential to consider risk-adjusted returns. This measure accounts for the risk taken to achieve a particular level of return, offering a more nuanced view of investment performance.

The Concept of Risk-Adjusted Returns

Risk-adjusted return is a calculation that evaluates how much risk was involved in generating a particular return. It allows investors to compare different investment opportunities on a like-for-like basis, even if they carry different levels of risk. In essence, it asks the question: “How much return did I get for the risk I took?”

Investors naturally seek to maximise returns, but the level of risk associated with those returns can vary significantly. A high return might seem attractive, but if it was achieved by taking on an excessive level of risk, it might not be a sustainable or wise investment. Risk-adjusted returns help investors identify assets that offer the best return for a given level of risk, making it a crucial metric for sound investment decision-making.

Key Metrics for Risk-Adjusted Returns

Several financial metrics help measure risk-adjusted returns in public markets. Each has its specific focus, but they all aim to provide a clearer picture of performance.

1. Sharpe Ratio
   One of the most popular metrics, the Sharpe ratio measures the excess return (over the risk-free rate) per unit of risk, where risk is defined by the investment’s standard deviation. A higher Sharpe ratio indicates that an investment offers a better risk-adjusted return.
2. Sortino Ratio
   Similar to the Sharpe ratio, the Sortino ratio also measures excess return per unit of risk but focuses only on downside risk. By considering only the negative deviations from the mean, it provides a clearer picture of how an investment performs in adverse conditions, ignoring the upside volatility.
3. Treynor Ratio
   The Treynor ratio compares the excess return of an investment relative to its beta, which measures its sensitivity to overall market movements. This ratio is particularly useful for investors who want to see how well an asset has performed relative to systematic risk, or market risk.
4. Alpha
   Alpha is a measure of an investment’s performance compared to a market index or benchmark. A positive alpha indicates that the investment has outperformed the benchmark, adjusting for the risk taken. A negative alpha suggests underperformance.

Private Markets & Measuring Risk-Adjusted Returns

While risk-adjusted returns are useful in public markets, they are harder to evaluate for private market investments like private equity and private credit. These investments face unique challenges that complicate accurate risk assessment:

1. Lack of Transparency
   Private investments typically disclose less information than public assets, making it difficult to fully understand risks. Without clear data on underlying assets, fees, and performance, accurately gauging risk-adjusted returns can be challenging.
2. Illiquidity
   Private investments are often illiquid, meaning they can’t be quickly sold or valued. Traditional risk metrics may not account for this illiquidity risk, potentially overstating the risk-adjusted returns.
3. Valuation Difficulties
   Unlike publicly traded stocks, private assets are valued less frequently, often based on estimates. This inconsistency can obscure the true level of risk and make comparisons across investments unreliable.
4. Limited Historical Data
   Private investments may lack consistent historical data, complicating the calculation of metrics like volatility, which are essential for assessing risk. Long investment horizons and irregular reporting add to the challenge.

Public vs. Private Markets

Why Risk-Adjusted Returns Matter

Investors can be misled by high returns if they don’t account for the risk involved as is often the case in private markets where a clear delineation of risk is rarely drawn. Risk-adjusted returns provide a more accurate assessment of an investment’s performance, enabling better comparisons between options. For instance, an investment offering a 10% return might seem appealing, but if it involves a high level of risk, a safer asset with a 7% return and a better risk-adjusted profile might be a smarter choice.

Moreover, risk-adjusted returns are critical for portfolio management. They help investors build diversified portfolios that balance risk and reward, aligning investments with their risk tolerance and financial goals.

Conclusion

Risk-adjusted returns offer a more realistic perspective on investment performance, helping investors make informed decisions. By considering both returns and the risk taken to achieve them, they can identify the most efficient investments and construct portfolios that meet their objectives. Whether you’re a seasoned investor or just starting out, understanding risk-adjusted returns is essential for navigating the complex world of finance with confidence.

If you are considering private market investments, Kingsbury & Partners and our Private Markets divisions is tasked with, as we term it, ‘’regulating the unregulated’’ and offering clients and partners ultimate transparency on various private equity and private credit opportunities in the offshore market.