17th letter to friends of Brunei [Portfolio Management (Part 3)]

Having assembled a porfolio of assets, we need to have a system of evaluating the performance. We can use:

A. Non-Risk Adjusted Measurements

1. Net Asset Value(NAV): a quick measurement on the net asset value(assets - liabilities) per unit of the portfolio;

2. Total return: for a quick measuring of a return in dollar amount after an investment period;

3. Arithmetic Mean: measures the average return of the portfolio;

4. Geometric Mean: measures the annual compounded return of the portfolio; &

5. More complex measurements like Dollar-Weighted Rate of Return (DWRR) and Time-Weighted Rate of Return (TWRR).

B. Risk-Adjusted Portfolio Returns

I will illustrate more on these type of portfolio returns, which is commonly cited in major business papers on investment value tables.

1. Sharpe Ratio

The Sharpe Ratio measures the excess return (or risk premium: Portfolio Return[Rp] - Risk free Return [R f]) per unit of Portfolio Total Risk (or portfolio's standard deviation: σp).

Sharpe Ratio = (Rp - Rf )/σp

On 1st glance, the following funds' ranking look like this:

Rank 1: China Growth Fund(return: 15%, risk: 16%)

Rank 2: India Growth Fund(return:13%, risk: 18%)

Rank 3: Emerging Market Growth Fund (return 12%, risk: 11%)

The ranking would be different if you use Sharpe Ratio (assuming risk-free return is 7%), the ranking is:

Rank 1: China Growth Fund: Sharpe Ratio: (15% - 7%) /16% = 0.5

Rank 2: Emerging Market Growth Fund: Sharpe Ratio: (12% - 7%) /11% = 0.45

Rank 3: India Growth Fund: Sharpe Ratio: (13% - 7%) /18% = 0.33

Above example shows that by taking risk into consideration, the decision on which fund to invest can be different.