Measuring your ‘Height’ using Risk Adjusted Returns
As a golfer, one of my favorite movies of all time is Caddy Shack. It is a classic. And there is a great quote in that movie:
Judge Smails: Ty, what did you shoot today?
Ty Webb: Oh, Judge, I don’t keep score.
Judge Smails: Then how do you measure yourself with other golfers?
Ty Webb: By height.
I love that quote! Of course, Chevy Chase is tall so it was a smart answer!
That quote always brings me back to measuring the success of any asset manager and our focus here at ZEGA on Risk Adjusted Returns.
Any advisor can find and measure returns but without the context of the risk that was taken by the portfolio to generate those returns, then the return number is not as valuable. Simply put, if you had high returns in the last year but your portfolio manager took a lot of risk to get those returns, then the risk adjusted returns would not be as good. And on the opposite end, if you had high returns but your manager took low risk to generate those returns, then the risk-adjusted returns would be considered stronger.
On Wall Street, the most commonly used measure for risk in asset management is Standard deviation of returns. Usually, it is calculated as the standard deviation of the monthly gross returns and then annualized by multiplying that standard deviation by the square root of 12. So, if you want to compare several strategies, make sure to compare both the returns and the standard deviation of the returns over the same time period.
So, we decided to try an exercise where we can compare ourselves ‘by height’ to other strategies. One of the best places to find both returns and standard deviation of returns is the Morningstar database of Mutual Funds. There are thousands of mutual funds in the database and many of those managers are managing money in similar categories as ZEGA Financial. So, we like to compare ourselves to those managers. But, we think the most effective way to compare ourselves is to line ourselves up ‘by height’ first and make sure everyone is similar in height (ie, standard deviation).
How do we do that? We determine the standard deviation of our strategy and then screen in Morningstar for similar strategies that have a similar standard deviation (ie, similar height). Then we line them up by returns to see which ones deliver the best returns and group them by decile. Then, we see where our ZEGA strategy would rank in the decile returns.
Let’s look at the Internet Advantage Strategy (IAS) – Equity Best Picks first. As you can see in the chart below, it ranks in the very best decile. In fact, its +27.4% returns in the twelve months ending April 2017 would place it in the top 2% of all of these Funds. It has a 8.56 standard deviation for the same 12 month window.
And if you look at the IAS Equity Long Short strategy, it places in the top quartile of funds for its +9.39% returns over the trailing 12 months when compared with Open ended Mutual Funds in the Alternatives category that had a similar standard deviation. The IAS Equity Long Short strategy had a 6.77 standard deviation for that same time period.
We really like using this measurement for comparing strategies and determining if your asset manager is adding value compared to the ACTUAL risk they took over that same time period. In fact, if you are an advisor and have access to Morningstar database, we are happy to show you how to run this for your client allocations so you can show your clients the returns they have received compared to the risk of those returns (ie, the standard deviation).
You can access the list of Funds from our screen that were generated from the Morningstar database to determine these calculations in this spreadsheet.
If you want to learn more about these returns and understand the risk-adjusted returns more, call us!
All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is no guarantee of future results and there can be no assurance, and clients should not assume, that future performance of any of the model portfolios will be comparable to past performance.
The performance figures illustrated in the Internet Advantage Strategies represent the actual aggregated performance of the Strategies in ZEGA’s client and employee accounts. Performance numbers displayed net of fees include a 1.50% fee; this fee is an estimate which reflects both ZEGA’s management fee and the fee charged by the advisor to the client. Both strategies became actively managed in the fourth quarter of 2014. These results should not be viewed as indicative of the advisor’s skill. The prior performance figures indicated herein represent portfolio performance for only a short time period, and may not be indicative of the returns or volatility each model portfolio will generate over a long time period. The performance of the models should also be viewed in the context of the broad market and general economic conditions prevailing during the periods covered by the performance information. The actual results for the comparable periods would also have varied from the model portfolio results based upon the timing of contributions and withdrawals from individual client accounts. The performance figures contained herein should be viewed in the context of the various risk/return profiles and asset allocation methodologies utilized by the asset allocation strategists in developing their model portfolios, and should be accompanied or preceded by the model.
Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility.
The S&P 500 Index – a broad-based unmanaged measurement of changes in stock market conditions based on the average of 500 widely held common stocks.