Risk Adjusted Return – Compare Mutual Funds on a Common Basis
Risk-adjusted return provides a simple means of comparing similar mutual funds on a common basis. As similar mutual funds usually are not equivalent in terms of risk, simply comparing their average returns is not a valid means of selecting the best mutual fund.
Similar mutual funds are those that are in the same category or asset class. In other words, compare large cap value to large cap value, technology to technology, emerging markets to emerging markets and so on. It’s important to understand that using risk-adjusted returns to compare mutual funds in different categories may be interesting, and useful in getting a feel for the relative risk of different asset classes, but it’s not a valid means of selecting mutual funds, as mutual funds in different asset classes are not alternative investments, they are complementary investments in a well-diversified portfolio.
The Sharpe ratio has long been used as a risk-to-return performance measure. The Sharpe ratio is computed by dividing the average excess return by the standard deviation of excess returns, where excess return is the actual return less the average T-Bill rate for the same period. The result is a measure of excess return per unit of risk. This is a very significant and useful statistic but it is not particularly intuitive to the average investor, who is accustomed to thinking in terms of actual returns. The Sharpe ratio is the best purely quantitative measure for comparing mutual funds, but for most investors, comparing risk-adjusted returns is a necessary step in the process, as it makes the comparison in terms with which they are familiar.
Modigliani and Modigliani recognized that average investors did not find the Sharpe ratio intuitive and addressed this shortcoming by multiplying the Sharpe ratio by the standard deviation of the excess returns on a broad market index, such as the S&P 500 or the Wilshire 5000, for the same time period. This yields the risk-adjusted excess return. This, too, is a significant and useful statistic, as it measures the return in excess of the risk-free rate, which is the basis from which all risky investments should be measured. However, this still falls a bit short of being truly intuitive to the average investor, and excess returns are not part of the mutual fund data that is ordinarily published.
To produce a number that is intuitive and significant to the average investor, actual average return should be divided by the standard deviation of actual returns and the result then multiplied by the standard deviation of the actual returns of a relevant index for the same period of time. (A broad market index can be used in lieu of an index that is representative of the category but the result will be less relevant.) The result is a risk-adjusted return that is derived from and relates directly to published returns and is thus a more intuitive measure for the average investor. A mutual fund’s risk-adjusted return is what a fund would have returned if its level of risk, as measured by the standard deviation of returns, was the same as that of the benchmark index.
Not much is lost by computing risk-adjusted returns in this manner and the result is much more useful to the general public. What is lost is the measure of excess returns, but that isn’t the objective of computing risk-adjusted returns. Rather, the objective is to compare mutual funds on a relative basis in terms that are meaningful to the average investor. As long as the funds that are being compared are similar in nature and their returns cover the same period of time, using the risk-adjusted return for comparing mutual funds is reasonably reliable basis for selection that will lead you to the same selection as the Sharpe ratio more often than not. However, as the possibility of a sub-optimal selection exists, it’s best to use go one more step with the quantitative analysis.
The final quantitative step in the comparison should be the use of the Sharpe ratio, which is an absolute measure of risk-to-return that is widely published and therefore doesn’t need to be calculated. The fund with the highest Sharpe ratio should be selected and usually this will be the fund with the highest risk-adjusted return. Mathematically, computing the risk-adjusted return from actual returns is not as reliable for identifying the best mutual fund but it’s not as abstract as the Sharpe ratio.
Using risk-adjusted returns to gain an understanding of the relative performance of mutual funds then validating the comparison with the Sharpe ratio is a good strategy for the average investor for comparing mutual funds.
Risk Adjusted Return – Compare Mutual Funds on a Common Basis

See Comparing Mutual Funds with Key Statistics for a detailed discussion of the use of risk-adjusted returns and other key statistics for comparing mutual funds at Your Complete Guide to Investing in Mutual Funds.
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