Dr Iqbal Survé saying a few words during the Raging Bull Awards event. Picture Courtney Africa, Independent Newspapers.
If “past performance is no indicator of future performance”, as we often hear repeated in the context of market-based investments, what is the value to investors of the Raging Bull Awards?
While past performance cannot be relied on to predict future performance, it is important when it comes to choosing an investment. What else do you have to go on? A portfolio manager’s reputation is established by his or her past performance – this is equally the case when choosing a doctor, a plumber, or a mechanic for your car. New kids on the block may be just as good, if not better, but you don't know that until they have a history of performance on which you can make a judgement.
There are different ways to look at the performance of a fund. It cannot be over too short a term, such as one or two years. A portfolio manager could simply have “got lucky”.
To better gauge a portfolio manager’s investment prowess – and even the best managers get their decisions right not more than about 55% of the time – one must look not only at performance over the longer term (preferably five years or more), but at the consistency of that performance, or, in statistical language, the extent to which investment returns deviate from the mean (or not).
Volatility risk
Here are two sets of numbers, with the same arithmetic average, or mean. (Note that one cannot apply the arithmetic mean to investment performance because returns on returns are exponential. This just illustrates the point in a simple way.)
The mean of each set of 10 numbers is 3. But notice the difference. In Set A the numbers fluctuate wildly, the highest being 8 and the lowest being -3. In Set B the numbers “huddle” around the mean, the highest being 5 and the lowest being 1.
In investing, the more performance deviates from the mean, the more volatile the investment is and the less consistent the outcome. This is known as volatility risk, and it applies particularly to stock-market investments. Portfolio managers therefore work to balance volatility risk and returns. While this may temper returns in the short term, it brings more consistent, reliable performance over longer periods.
The Raging Bull Awards recognise straight performance over three years, but the awards most prized by investment managers and most relevant to investors are those that recognise risk-adjusted performance over five years.
Risk-adjusted performance
Risk-adjusted performance takes into account both returns and volatility risk. For the upcoming awards in January, for performance to the end of 2024, this will be measured using the Sortino Ratio.
The Sortino Ratio is a derivation of the Sharpe Ratio, developed in the 1960s by US economist William F Sharpe. Both ratios use a formula that takes into account returns over a certain period (in this case five years), volatility (deviation from the mean, or standard deviation in statistical terms), and the “risk-free rate” of the period. The risk-free rate is the return you would get on a virtually zero-risk investment such as a government bond. The difference between the Sharpe and Sortino ratios is that the latter takes into account only downside deviation from the mean, which is detrimental to overall returns, unlike upside deviation.
The ratios give you a number between roughly -1 and 6. A number greater than one denotes high returns relative to volatility.
Wikipedia notes that Warren Buffett’s investment company Berkshire Hathaway had a Sharpe Ratio of 0.76 over the 35 years from 1976 to 2011, compared with the US stock market’s 0.39 for the same period.
A word from Manager of the Year
The importance for asset managers and investors of considering risk-adjusted returns is well summed up by Cornelius Zeeman, equity portfolio manager at Fairtree. This Cape-Town-based firm has won a string of Raging Bull awards over the past several years and is the proud holder of the SA Manager of the Year award.
“Not all returns are equal. Investments with high returns may come with high volatility. Risk-adjusted returns highlight how much risk is associated with achieving those returns, which can be crucial for making informed decisions. A fund that delivers consistent, robust returns relative to the risks taken demonstrates disciplined investment management, a repeatable process, effective diversification, and resilience in varying market conditions.
“At Fairtree we focus on achieving superior risk-adjusted returns, ensuring our investors benefit from sustainable growth while minimising exposure to unnecessary volatility. This approach protects capital during market downturns and positions portfolios to take advantage of opportunities. Selecting a fund with a strong track record of risk-adjusted returns is an essential step towards sustainable wealth creation,” Zeeman says.
* Hesse is the former editor of Personal Finance and Raging Bull Awards consultant.
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