Q. I am currently reviewing my portfolio of managed funds.  I have been comparing the performance relative to published market indexes. Fair to say the performance of some of the managers has underperformed the applicable index.  In reviewing my portfolio what other factors should I be considering when deciding what to keep and what to ditch?

A. The challenge when assessing the performance of a portfolio is what metric should be used.  Quite understandably most investors focus on returns made relative to an index or a benchmark that reflects the average in the particular market sector you are investing in.

When comparing the plethora of Managed funds available in the market, the majority of investors focus on historic investment performance which is reflected in a measure called the rate of return.  After all historical returns are easily identifiable and readily available in ranking charts that compare past performance.

It is vitally important to recognize that relative performance based on the rate of return is a historical guide comparing various Fund Manager’s investment decisions at a given point in time.  It by no means is a predictor of the future performance outlook for a fund.

Selecting investments purely on past performance is a fraught exercise. Past performance is only one measure and frankly the least important measure of likely future prospects.  The greater challenge is assessing and measuring the level of risk taken to generate a particular return and the potential for downside losses.

When reviewing a portfolio, you must first take into consideration your investment objectives.  These objectives will be determined by your time frame for investing, your appetite for risk and the timing of investing in the investment cycle, often referred to as “sequencing risk”.

Once investment objectives have been considered, there are two important quantitative measures that provide further insights as to the risks of an investment fund, as well a measurement of the investments likely behaviour under different market conditions.

These two measures are referred to as; an investments “Standard Deviation” and the “Sharpe Ratio” which measures the relative return on an investment taking into consideration the risks taken to generate the return.

A Managed Fund’s Standard Deviation is a measure of the price dispersion. That is, how volatile a fund performance has been and how wide is the range in the value of the investment over a given period.  The higher the standard deviation, the more vulnerable the fund to volatile performance and wide swings in value and performance.  This is important to an investor that may be uncomfortable with rapid movements in valuation and capital losses as well as being a factor when considering both the time horizon and timing of an investment.

The Sharpe Ratio is calculated as the average return earned in excess of the risk-free rate of return (typically we use the official RBA interest rate) per unit of volatility or total risk, where volatility is measured through the investment’s Standard Deviation. The Sharpe Ratio describes now much excess return you are receiving on an investment allowing for the extra volatility you are prepared to experience to generate the outperformance.  Essentially it allows investors to compare different investments on a like-for-like basis allowing for risk. The higher the Sharpe ratio of a fund is, the higher the relative performance of the fund allowing for volatility.

Risk and return must be evaluated when considering investment choices. The higher the standard deviation the higher the likely risks to an investor. As such, the risk must always be considered along with the return when you are looking to choose your investments. The Sharpe ratio can help you determine the investment choice that will deliver the highest reward while considering risk.

There is a range of online calculators available to calculate both Standard Deviation and the Sharpe Ratio of various funds.  Alternatively, ask your Financial Adviser or your Fund Managers to provide this information.

When reviewing your portfolio, first consider your investment objectives.  Review your portfolio rate of return but also take into consideration the risks the Portfolio Managers are taking to generate that rate of return.