This read shares a holistic perspective on some of the concepts within investment management and complements the online course on Essentials of Investment Management posted on The Middle Road. Essentials of Investment Management is an excellent well rounded online course on understanding various concepts within portfolio management and investment management parlance keeping the capital asset pricing model (CAPM) framework in mind. For investors an ideal portfolio will be the market portfolio that will consists of all liquid assets in the world. The most efficient portfolio will be the minimum variance portfolio with a set of portfolios that lie on the efficient frontier. Sadly, practically people don’t implement this feature. All these concepts are discussed as part of the online course on Essentials of Investment Management. Coming back to investing especially for retail investors who invest in mutual funds, it’s important to invest across a diversified set of mutual funds including index funds. Index funds are passive funds that can be either index mutual funds or ETFs. ETFs or exchange traded funds are traded on exchanges and unlike Index funds have higher liquidity. However, both these funds track a benchmark index example S&P 500, Nifty 50 and are supposed to replicate the index i.e. in other words their Alpha is zero. Couple of key variables to choose are low expense ratio and tracking error. Tracking error shares an accurate picture of how faithfully are the passive funds replicating the benchmark index. Both these variables must be low, the lower the better. Two ratios you must analyze for tracking the performance of passive funds are the Sortino Ratio and Information Ratio.
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Capital Market Line is a special type of Capital Allocation Line, the risky portfolio is the market portfolio. Capital Allocation Line is a combination of risk-free asset with optimal risky portfolios. Risk-free asset has zero variance and zero correlation with risky assets. This factor is important when you combine a risky asset with a risk-free asset, the standard deviation of the portfolio is linearly proportional to the risky asset. Efficient Frontier, a concept widely discussed in the online course on investment management, is an important concept in modern portfolio theory and investment management. Efficient Frontier are set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. To know more about Capital Market Line, Efficient Frontier and Portfolio Management, refer to the online course on investment management. Check out the course below.
Information Ratio
The Information Ratio standardizes tracking error across asset managers by dividing the excess return over risk free rate by tracking error. A high information ratio indicates the asset manager is delivering superior returns over the risk-free rate with a low tracking error. This ratio helps in understanding various index funds in mutual funds keeping the benchmark index constant. Its important to understand that the risk-free rate will be lower among advanced countries compared to emerging countries. A more developed market will have a more liquid and supplicated capital markets with lower cost of raising funds. Among peers within similar basket of countries with economic development, a lower risk-free rate signifies lower cost of borrowing for corporates. In the US, yields of T bills are a barometer of risk-free rate while in India yield of a 10 year G-sec could be taken as risk free rate. The yield between developed country example a 10 yield on US government bond and yield of similar 10 year both of other countries will signify the risk premium linked to the sovereign risk of that particular country. This concept is discussed in the Introduction to Investment Valuation online course.
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Risk Adjusted Return
Usually, the widely used risk adjusted return is the Sharpe ratio. In the Sharpe Ratio, expected return over the risk-free rate is divided by the standard deviation of the asset manager. Standard Deviation or Variance, which is the square of standard deviation, is an adequate barometer for quantifying risk. The Sharpe Ratio measures both the upside and downside volatility of the asset class. The Sortino Ratio captures only the downside risk. This means only the negative standard deviation of the asset manager is calculated. Treynor Ratio is another excellent measure to capture the risk of the asset manager with a benchmark index designated as beta. Beta can be termed as the covariance of the asset manager with the benchmark index. A beta of 1 means the asset manager or stock is expected to give a 100 percent return if the benchmark index goes up by 100 percent, or fall by 100 percent if the benchmark index falls by 100 percent. Let’s consider the Indian stock exchange NSE. Stocks in NSE with betas greater than 1 are called high beta stocks. This means they are expected to deliver higher returns compared to their benchmark. This variable is captured through Jensen’s Alpha. Stocks with beta less than 1 are low beta stocks, which means they are less risky than high beta stocks and therefore their expected return will be less than higher beta stocks, keeping with the concept of risk and return. Usually, high beta stocks are high growth volatile stocks with higher leverage ratios more tuned to economic cycles example technology, while low beta stocks could be in well established companies for example in FMCG (Fast Moving Consumer Goods), for example Procter & Gamble and Hindustan Unilever Limited. (Keeping other factors constant) Procter & Gamble has a beta of 0.44, Hindustan Unilever Limited has a beta of 0.09. Alphabet has a beta higher than 1 (beta 1.06) while Microsoft less than 1 (beta 0.9) though both are top global technology companies. Beta information shared by Yahoo Finance.
Why is Alphabet’s beta more than Microsoft ? The answer lies in the business’ model of Alphabet.
Consider two stocks with similar returns over a period – one high beta stock and one low beta stock. Keeping all other factors equal, which stock has generated higher risk-adjusted returns?
The answer is the one with low beta, as this stock has generated higher risk adjusted return. This concept using the security market line is discussed in depth in the online course on investment management on The Middle Road.
Beta β measures risk of an asset proportion to the risk in the market portfolio. It measures the standardized covariance of the asset with the market portfolio. The expected return of an asset on SML depends on its beta and all assets that lie on SML are fairly valued or have an Alpha equal to zero. Undervalued stocks/assets will lie above the SML while overvalued below the SML. SML helps an asset manager in balancing the portfolio.
For investors investing in passive asset managers, for example index funds, Sortino and Information Ratio are excellent barometers to evaluate asset managers. Investors looking for active funds, especially mutual funds, must use all risk adjusted ratios keeping other financial ratios constant to arrive at a more judicious judgment for evaluating better investment ideas. It’s always important to look at the portfolio of mutual funds to understand the investment philosophy of the fund manager. Risk profile, investment horizon and other variables are hygiene factors before delving into analysing and picking asset managers. For investors investing directly in stocks a fundamental financial analysis of the company is essential rather than relying on risk adjusted returns.
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