4.2.1 Alternative measures
Peer group performance measures
Peer group performance measures can be used when there is no benchmark index available and allow comparison of funds within an appropriate peer group. The key measures of peer group performance are:
- Sharpe Ratio This measures how much is earned per unit of total risk taken on by the fund (the standard deviation of its returns). The ratio consists of two elements. The first element (the numerator) is the excess return of the fund relative to the risk-free rate. So if the return is 13% and the return to the risk-free asset is 3%, this means that the excess return is 10%. The second element (the denominator) is the standard deviation of returns to the fund. If, for example, the standard deviation is 10%, then with an excess return of 10% this gives a Sharpe Ratio of 1, considered to be a good performance. If the excess return is only 2%, the Sharpe Ratio would be a less impressive 0.2. Earning less than the risk-free rate, as fund managers did in 2008, would give a negative Sharpe Ratio!
- R 2 (R-squared) This is the percentage of the total risk of a portfolio that can be explained by market risk. The remainder is the percentage represented by specific risk. A high R-squared, say 90% or more, means that the fund closely resembles an index fund and is not following an active outperformance strategy.
Index benchmark performance measures
Where an index or other benchmark is specified, the following measures are used to judge performance relative to that benchmark:
- Alpha The difference between the return on the portfolio and the return on the benchmark, positive or negative, that can be derived by taking on specific risk – for example through stock selection.
- Beta A measure of the fund’s sensitivity to market movements. Fund managers use beta to engage in market timing. In a bull market, a fund with a beta of more than 1 will be expected to do well relative to the market; in a bear market, a beta of less than 1 will be expected to do less badly than the market.
- Tracking error This measures the volatility or standard deviation of the alpha over time. The larger the tracking error, the more likely a high outperformance or underperformance relative to the benchmark in any one period.
- Information ratio This is a risk-adjusted performance measure, that is, the alpha divided by the tracking error. This measure prefers funds that earn consistent, positive alphas, rather than higher but more volatile alphas over time.