Harlyn’s view on risk and return measurement

The Sharpe ratio is a measure of risk efficiency. It compares the excess annualised return from a portfolio (vs cash) with the annualised volatility of those returns, observed on a monthly basis. A Sharpe ratio of more than 1.00 means that an investor has been fully compensated for the extra risk he incurred by shifting his money out of cash. The problem with the Sharpe ratio is that it regards all volatility as bad volatility, whereas most investors regard upside volatility – i.e. rising returns as a good thing.

The Sortino ratio was developed to answer this criticism. It compares the annualised return with the downside volatility of a portfolio – i.e. the standard deviation of those periods when the performance has been negative or below a pre-determined hurdle rate. Provided the same hurdle rate is used for the both ratios, a Sortino ratio which is more than twice the Sharpe ratio shows that the portfolio offers better protection against loss than would be predicted simply from looking at the annualised volatility.

The Calmar ratio looks at disaster scenarios. It compares the average annualised return with the maximum peak-to-trough loss in the period. Annualised returns are divided by the maximum loss, with a high number being better than a low number. Conventionally this ratio is calculated over three years, but we think this period is too short to capture the risks inherent in a full investment cycle. We regard 10 years as a bare minimum. The 15-year Calmar ratio for the sterling global equity /bond model is about 1.25 compared with 0.90 for UK gilts treasuries and 0.15 for UK equities.