“Why do academics always talk about risk adjusted returns? I get that risk matters and you shouldn’t have a riskier portfolio than you can manage. But if I compare two strategies over a period, I’m better off at the end if I used the strategy with the higher return, not the one with the higher risk adjusted return. So why is risk adjusted return relevant?”

1. January 2017
The above question is not uncommon and in essence the statement is true - any investor is
better off at the end if they invested in the highest returning strategy. The field of asset
management, however, would be vastly different if we had the foresight to know which strategy
would be the highest returning over any desired investment period. Practically, however,
investment markets have to be navigated in anticipation of uncertain future returns, resulting in a
decision-making process that is not as straight forward. A risk adjusted return is a powerful
measure allowing an investor to, firstly, select a portfolio with the highest expected return that also
has the highest probability of delivering that return. Secondly, the measure can be used in a
retrospective analysis, as a means of testing whether the generated return was sufficient for the
uncertainties endured to achieve it.
Let’s consider two portfolios that generated the same return over a specific period despite
having had the possibility of vastly different outcomes at the outset. By definition portfolio risk is a
portfolio’s capacity to be negatively affected by an unanticipated event and directly as a result fails
to meet its financial objectives. Even though these events did not necessarily materialise during the
considered period, the sword of an unanticipated event always hangs over the head of any market.
The portfolio with the lower capacity to be negatively affected by these has a higher chance of
reproducing similar returns over a longer-term investment period, making it the safer and surer way
of attaining the expected return.
In assessing the success of invested capital over time, it is insufficient to judge its return
only by its relative outperformance of other strategies. This approach does not highlight massive
risks that might have been taken to generate mediocre returns, which is undesirable even if the risk
levels are within the investor’s tolerance. Simply put, if an equivalent return could have been
generated at a lower risk level, the investor in essence holds an underperforming asset which is not
being rewarded for the higher level of risk it is exposed to. A risk adjusted return calculation will
indicate if this is the case, and therefore remains a relevant measure to consider.
A portfolio’s capacity to be negatively affected by unanticipated events can be represented
by a number of quantitative measures. Some underlying risks typically influence the profile of
returns, and thus the vast majority of quantitative measures calculate a portfolio’s risk using its
historical returns. Volatility, for instance, is a measure that quantifies the frequency and severity
with which the price of an investment fluctuates. In addition to these, qualitative (what we call
“common sense”) measures of risk are also crucial to take into consideration.
Why is Risk Adjusted Return Relevant?
Elmien Wagenaar & Kobus Jansen van Vuuren
“Why do academics always talk about risk adjusted returns? I get that risk
matters and you shouldn’t have a riskier portfolio than you can manage.
But if I compare two strategies over a period, I’m better off at the end if I
used the strategy with the higher return, not the one with the higher risk
adjusted return. So why is risk adjusted return relevant?”

2. January 2017
Take two portfolios with identical historic returns and volatility, the one, however, is invested in
only a few shares while the other in many, or alternatively, the one is invested only in the financial
sector while the other is diversified across sectors. The portfolio with the larger number of shares or
larger diversification across sectors will always have a lower capacity to be affected by adverse
events. These portfolios will have a higher risk adjusted return, and we would therefore always
rather invest in them.
Disclaimer
The RCIS Think Growth QI Hedge Fund is managed by THINK.CAPITAL Investment Management Proprietary Limited in terms of a discretionary mandate. THINK.CAPITAL is an
authorised financial services provider (FSP 46714) in terms of the FAIS Act. This document has been compiled for information purposes only. It is provided in good faith and has been
derived from sources believed to be reliable and accurate. No representation or warranty, express or implied, is made in relation to the accuracy or completeness of this information. It
does not take into account the needs or circumstances of any person or constitute advice of any kind. It is not an offer to sell or an invitation to invest. Past investment performance is
not a guarantee or indicative of future performance. Returns are subject to fluctuation and may be volatile. Returns are net of costs and for a particular fee class. Collective Investment
Schemes are generally medium- to long-term investments. An investor may not get back the full amount invested. No responsibility or liability is accepted by THINK.CAPITAL, its
subsidiaries and its associated companies and/or the directors, employees or agents of THINK.CAPITAL for any loss arising from the use of this information. It is the investor’s
responsibility to inform him or herself of and comply with regulations and applicable laws in the relevant jurisdiction in which they operate. The RCIS THINK Growth QI Hedge Fund is a
collective investment scheme regulated by the Financial Services Board.
Risk adjusted return is a means of finding and maintaining the most
robust portfolio – the highest returning strategy with the highest
likelihood of attaining its financial objectives.