Of Alpha and Sharpe’s: A Look at Risk and Return
CH has always believed in the benefit of active investment management like portfolio managers making decisions in what assets a client should own within a mutual fund rather than taking a passive investment approach like buying and holding a mutual fund or ETF that tracks an index. Two of the most important tools we use for monitoring and measuring the success of a specific portfolio manager are known as Alpha and the Sharpe Ratio.
What is Alpha?
Alpha measures the ability of an investment strategy’s ability to outperform its benchmark and its peer group. By definition, an index will always have an Alpha of zero. Investments like index ETFs will therefore have an Alpha of slightly less than zero to account for the fee being charged to run it.
Active managers, by contrast, will want to show positive Alpha, meaning they are outperforming that index net of their fees. The higher the Alpha typically the better. The one limitation of this measurement is that it does not account for how much risk the manager is taking on, and that brings us to the Sharpe Ratio.
What is the Sharpe Ratio?
The Sharpe Ratio seeks to measure the total return of an investment compared to the investment’s risk. Created by Dr. William Sharpe in 1966 this ratio was designed to measure the average return earned over the risk-free rate per unit of total risk. Normally the risk-free rate is how much can be earned on a high-interest savings account, and risk is measured by the level of volatility within a fund, also known as the standard deviation. Generally speaking the higher the Sharpe Ratio the better as a high rate of return with low volatility is what most investors are looking for.
How does Alpha and the Sharpe Ratio affect your portfolio?
Alpha highlights the value of an active investment approach compared to a passive strategy. At CH, we are constantly monitoring the performance of our portfolio managers compared to the index and our managers’ peers. This is because any underperformance could signal something no longer working for the portfolio manager and their team, or that the mutual fund’s mandate no longer works with current market conditions.
We are also looking for ways to increase the Sharpe Ratio for our clients. We diversify clients’ portfolios with assets that have low correlations which decreases a clients’ portfolio risk without sacrificing too much return. This is part of CH’s philosophy that our clients should participate in returns when the market is performing well while protecting their capital when markets are underperforming.
As always the team at CH keeps an eye on all of these indicators and focuses especially on 3, 5, and 10-year performance numbers to give us context. By definition, an active manager will underperform from time to time. It is a part of being different from the market. But these managers are expected to outperform and/or lower our client’s risk over the long term, showing the value that they add through their work.
Although these are not the only tools portfolio managers and CH use to analyze risk and return within our clients’ portfolios, they are important. Hopefully, this article has helped to explain what these tools are, and how we use them.
As always, we welcome any questions or comments.
All the best,
Devin Gorgchuck, Wealth Advisor
& Your CH Financial Team
All the best,