Director of Risk Management Gunjan Banati explains why rolling returns and risk-adjusted returns are more robust ways to look at fund performance.
Watch the video here.
Many investors, when they’re looking to evaluate the performance of a fund, they’re looking at standardized returns. Those are returns that are point-in-time snapshots of a one-, three- or five-year period.
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Or they might be looking at calendar year returns, which is a single snapshot for that calendar year. What we find is a much more robust way to look at returns is to do so on a rolling basis.
What Are Rolling Returns?
A rolling return is when you look at a period return, but you don’t just look at it starting in January, you also look at it starting in February, March and April, and you continue to move forward.
This gives you many more data points for that period return, you’re seeing it over multiple months, and you’re also moving forward and covering that return period over different market cycles, over different market environments, and it gives you a much broader picture of how that particular investment manager would perform in different environments.
Risk-adjusted Returns Using Sharpe Ratio
Another way to look at performance is on a risk-adjusted basis. One way to do that is to use something called the Sharpe ratio.
Let me first explain how the Sharpe ratio is calculated. You take the return of the investment over a period, you subtract out the risk-free rate, and then you divide it by the standard deviation for that same period.
So, the Sharpe ratio provides you with the excess return you receive for the extra volatility you’re taking for that investment.
Rolling Sharpe Ratios Are Robust
Probably one of the most robust ways to evaluate, especially an active manager, where performance differs greatly from the benchmark, either above or below, is to combine these techniques, and look at rolling Sharpe ratio. So, look at rolling risk-adjusted returns.
One of the main advantages of using the Sharpe ratio is that it allows you to compare the performance of two funds on a risk adjusted basis. So, for example, if you had two funds that had exactly the same return, you would have no real understanding of how they achieved that return, how they actually got there, and what that experience was like. By looking at the Sharpe ratio, you can understand what risk was taken to achieve that return.
It’s important to note that a higher Sharpe ratio does not necessarily represent lower volatility. What it does represent is a better risk-adjusted performance. So, you’re getting a higher return for the risks that you are taking.
Why Should an Investor Use These Tools?
When an investor looks at standardized returns or calendar year returns, they’re looking at an arbitrary time period for a return. If they truly want to evaluate, especially an active manager whose performance may deviate greatly from the benchmark, the best way to do that is to do it on a rolling basis, and to do it using risk-adjusted returns, because that way you get a much broader picture over time of the performance, and you’re also accounting for the risks that the portfolio manager has taken to achieve that return.
Article by Gunjan Banati, The Royce Funds