Thursday, December 18, 2014

Answer questions - volatility/risk adjusted measures of return


Hello everyone. This is the second week after level 1 exam, but for level 2 candidates, you might want to start thinking about level 2 exam strategy while enjoying this holiday season.

Investors seem to be in good mood this week. With oil price continue to hit the bottoms, energy stocks went down considerably for sometime now until this Monday. I’ve always said market timing is not for everyone, if you went in this week with certain names, you can possibly and easily profit 10 to 12%. If only we have a crystal ball.

A very timely question was asked a couple of days ago, market volatility.  This is a never ending topic ever since the financial markets were first created. Volatility has always been there with every generation of investors. The early 70’s, late 90’s, and more recently 2008/2009 crisis, investors have seen market downturns all the time. Here, I will try to outline a few concepts that have been asked in the comments.

First things first, we use beta to measure a security’s systematic risk against the market or benchmark. If a stock has a beta of 1.5, it means the stock will be 50% more sensitive than the market depending on which way the market goes. If the market goes down, the stock will go down by 1.5 times more than the market. Beta can also be negative, which means the security moves in the opposite direction than the market. If a security has a negative beta, using the CAPM the expected return will be negative.

This leads us to alpha. Alpha is the excess return of portfolio relative to its benchmark, and is used to measure active returns that can be defined by (Actual returns – Benchmark return). Jensen’s alpha builds upon the concept and takes into account the expected returns calculated by CAPM. It’s a risk adjusted measure of return. If a portfolio has an alpha of 3%, that means the portfolio outperformed the benchmark by 3%. This stat is used to measure active managers performance to compare whether their investment strategy or stock picking skills can beat the market or not.

The coefficient of determination in regression analysis, a.k.a. R-Squared, indicates how well a sample data fits a regression model (this is part of quant section). Specifically, a higher R-squared indicates the regression model is a good fit for the data sample. In investments, the R-squared indicates how well the portfolio return is explained by the benchmark index. It takes a value of 0 to 100, for example a R-squared of 85 means the 85% of the portfolio return can be explained by the index. In that case, you will want to also look at the beta, because the fact that a majority of the data can be explained by the market, beta would be a meaningful measurement.

Sharpe, sortino and treynor are all risk adjusted measures of a portfolio returns. The difference is what risk each ratio is measured against - the denominator
  1. Sharpe ratio is risk adjusted against the portfolio’s standard deviation
  2. Sortino ratio is risk adjusted against the standard deviation of negative asset returns or downside deviation,
  3. Treynor is risk adjusted against the market risk beta 
To better understand these concepts, think of these as the excess returns per unit of risk. Different risks are measured in different ways. Standard deviation tells you the total portfolio risk, excess returns per unit of total risk is sharpe. Given a highly volatile portfolio, you might want to measure downside risk in particular, excess return per unit of downside risk is sortino ratio, and you can measure excess return per unit of systematic risk, which is treynor.

Downside or upside capture ratio provides you with the comparison of investment performance against the market. It goes without saying, a 50% downside capture ratio means that the investment will go down by 0.5 when the market goes down by 1. A negative capture ratio is possible, it simply means the investment return takes the opposite direction than the market. A negative downside capture means when the market goes down, your investment actually goes up.

Hope this answers the questions. I had to come back to the writing of this post a few times this week, so it may not flow well but hopefully it delivers the message.    

4 comments:

Anonymous said...

Thanks a lot for the post, very useful and helpful! you are the best!!!! Just a quick question: what is CAPM ? I know it may sound stupid but i dont really understand this CAPM.
Actually i don't understand when you say If a security has a negative beta, using the CAPM the expected return will be negative ?
Why the expected return will be negative if the security has a negative beta? you mean when the market is down or up?
Thanks

PassCFAExams said...

Hi Anonymous, thanks for your comments. The CAPM is short for Capital Asset Pricing Model, it's very widely used in the finance industry. It uses beta in the formula to derive the expect reture of a security. If you can let me know your background of investments, I can try to position future posts accordingly. Thanks.

Laura said...

Thanks for the post. Very well explained. I'm just a bit confused with your blog new layout but I'm ok with it.
I guess it is new year soon and you want a new look for your blog :)
Sometimes old things are better :)
Looking forward your notes, especially for level 2. So if I ONLY READ your notes level 2, can I pass the exam without reading the official books? Thanks

PassCFAExams said...

Hi Laura,

I apologize for the new look, the reason I've changed the layout is to show the main content first, the new layout seemed to give the post a bit more space, then there's the other stuff. And you are right, it's a new year soon :)

AS to the notes, I am hoping the notes can cover the main concepts so you don't need to read the books, but the CFA books can be not replaced no matter what notes you use, you can go back to the CFA books for more details and practice questions.