Relative risk metrics measure volatility and the comparable risk of potential investments relative to the broader market. They include:
When it comes to investing, tracking error measures the standard deviation of excess returns compared with a common benchmark. In other words, it measures the volatility of excess returns of a security relative to a benchmark. For example, a fund with a tracking error of 10 basis points relative to its benchmark should return between 9.9% and 10.1% annually if the benchmark returns 10% each year.
The Sharpe ratio represents the risk-adjusted return of a portfolio. In other words, it measures how much return is being earned for each unit of risk assumed.
If the ratio is negative, it means the portfolio underperforms risk-free assets, such as a U.S. Treasury bill.
For instance, VTSAX, TNFAX, PRDGX and FGMNX all have positive Sharpe ratios, which means they outperform safe-haven assets like government bonds. Although FGMNX barely outperforms risk-free assets, it has a better rate of return than the broader U.S. Intermediate Government Bond category, which has a negative Sharpe ratio.
The information ratio is another risk metric used by portfolio managers to analyze the risk-adjusted return of an investment versus a benchmark.
It is calculated by dividing an asset’s excess return by
its tracking error relative to the benchmark.
Beta is another commonly used risk ratio that measures volatility of an investment relative to the market as a whole.
It is expressed as a positive integer, with 1 representing a perfect match between security and the overall market’s performance. Any number above that indicates that the investment in question will have greater volatility than the overall market.
For instance, PRDGX and FGMNX have betas that are lower than 1, which means they are more stable than the overall market. VTSAX’s performance is virtually in line with the broader market since its beta is 1.02. With a beta of 1.36, TNFAX varies more significantly.
The Treynor ratio measures the risk-adjusted return of a portfolio relative to the overall market.
It essentially compares an investment’s excess return relative to a risk-free asset (i.e., U.S. Treasury) divided by the asset’s beta. This metric is only useful if we assume that the portfolio manager has accounted for unsystematic risk (i.e., company-level risk).