Tag: returns

Alpha, Beta, Sharpe and Information Ratio

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ten-year returns

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StockViz now had alpha, beta, Sharpe and information ratio values available for individual stocks. The calculations are done daily using 1 year’s worth of historical data.

“Alpha” is a measure of a manager’s skill by measuring the portion of the managers returns that are not attributable to “Beta”, or the portion of performance attributable to a benchmark. This is how “better” a stock is relative to owning the index (Nifty 50) outright.

“Beta” is similar to correlation. By definition, the market itself has a beta of 1.0. A stock whose returns vary more than the market’s returns has a beta whose absolute value is greater than 1. A stock whose returns vary less than the market’s returns has a beta with an absolute value less than 1.

The “Sharpe” ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

“Information Ratio” relates the degree to which an investment has beaten the benchmark to the consistency with which the investment has beaten the benchmark.

Read the returns series here.

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Returns on Reliance

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We had discussed how risk and return are two sides of the same coin (read the series here). Also, we looked at the high price correlation of Reliance vs. the Nifty 50 index. The question yet to be answered is this: given a choice between owning Reliance and owning the NIFTYBEES ETF, what should an investor do?

Lets look at the pros of owning the NIFTYBEES:

  1. The NIFTYBEES represent the broader market. Investors get a diversified, market-weighted portfolio.
  2. 8.73% of the NIFTYBEES is, in fact, Reliance. So investors do get a slice of exposure to Reliance.

Now what would be the disadvantages of owning the NIFTYBEES vs. owning Reliance outright?

  1. If Reliance out-performs the index, then investors only get a small (8.73%) of the increase
  2. Investors may not want to buy the entire index and might prefer a concentrated portfolio of just resource stocks, of which Reliance is one.

To answer this question, lets turn our heads to two measures: alpha and beta (discussed here.) Reliance has an alpha of -0.0002946529 and a beta of 1.027928. What this shows is that Reliance actually underperformed the index (a –ve alpha) and it more or less tracked the index (a beta close to 1; confirmed by our correlation study.)

We are in the process of rolling out alpha and beta of individual stocks against the Nifty 50 index. Stay tuned!

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Fees–the silent killer of investment returns

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My colleague Abhishek did an overview of how to look at investment returns (see here, here and here). Let me round out the series with a pet peeve of mine: fees.

Almost all packaged investments (mutual funds, ETFs, etc…) come with a built-in fee structure. Typically, passive ETFs have a lower fee (0.80% for NIFTYBEES, for example) and mutual funds average about 2% annually. So assume that you have a 10 year investment horizon. How do fees impact your total returns?

Lets assume that the market always goes up by 8% annually. So in 10 years, your IRR should be 8%, if you paid no fees. But it falls to 5.84% if you paid even 2% as an Expense Ratio. But the problem is that the market doesn’t go up every year but you will still pay that 2% to the bank.

Before 2008, fund companies estimated that the fees for closed-end funds averaged 6% of an investor’s return, the maximum by law for both types of funds, while the open-ended funds charged 1.75% on average.

The popularity of those high-fee funds back then shows that investors pay little attention to fees when they are amortized over the holding period. When it comes to assent management fees, fore-warned is fore-armed!

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Risk Adjusted Returns

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Mutual fund

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In my intro to calculating returns I had touched upon how to compare returns on different investments, you need to first adjust it for risk. There are three such measures that I consider important: alpha, beta and the Sharpe Ratio.

Alpha measures the ability of an investor to beat the market, thereby generating returns in excess of what might be possible by taking the same amount of risk. Essentially, an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally. Basically, you are paying your mutual fund for the alpha, compared to just buying the Nifty50 ETF.

Beta is similar to correlation (see: The Reliance on Correlation.) An asset has a Beta of zero if its returns change independently of changes in the market’s returns. A positive beta means that the asset’s returns generally follow the market’s returns. By definition, the market itself has a beta of 1.0. A stock whose returns vary more than the market’s returns has a beta whose absolute value is greater than 1. A stock whose returns vary less than the market’s returns has a beta with an absolute value less than 1.

And finally, the Sharpe ratio. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

Read More:
Sharpe: http://www.investopedia.com/terms/s/sharperatio.asp#ixzz1lmQd5BEB
Beta: http://en.wikipedia.org/wiki/Beta_(finance)
Alpha: http://en.wikipedia.org/wiki/Alpha_(investment)

Questions? Email me: abhi@stockviz.biz

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Real vs. Nominal Returns

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In my previous post about calculating returns, I briefly touched upon the notion of “risk adjusting” any projected returns to see if it makes sense compared to different investment options available. Today I’m going to discuss the biggest unavoidable risk of all: inflation.

Inflation is the erosion of value of money over time. i.e., as time progresses, the same Rupee buys less goods or services. We have all seen its effects first hand – I can’t think of single thing that has become cheaper over the years in India. So how does inflation affect investment decisions?

If you just took all your money and kept it in a vault, over a period of a year, you’ll get only 90% of it back. Where did the 10% go? Inflation took it (assuming a 10% annual inflation rate). Now imagine what happens if you socked away your money in a vault over a period of 10 years? How much will you get back then?

The rate of inflation plays a crucial role in calculating returns on investments. So important, in fact, that the way we calculated returns yesterday is called “nominal returns”. When you adjust nominal returns for inflation over the same period of time, you get “real returns.”

There are various measures of inflation depending on who it affects, but the most popular of them is the CPI – the Consumer Price Index. A good rule of thumb is to subtract nominal returns with the CPI to see how much you really end up making.

Different investments react differently to changes in inflation. For example, real assets, like real estate are supposed to be immune to inflation since their value is expected to rise along with it. Bonds perform poorly in an inflationary scenario because you get a fixed return. Stocks fall somewhere in between.

So its almost always a poor investment to keep cash in a vault. At the very least, your returns should at least match the rate of inflation.

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