Investment Performance Measures

In making investment decisions, an initial step is to examine the performance of various investment options, such as mutual funds, hedge funds, bonds and index ETFs. There are many different ways to measure an investment performance. For example, a mutual fund normally provides a simple annualized return for its past performance. Such measurement is not sufficient for sophisticated investor because it does not reveal the risk involved. To do a careful assessment one should gather the past return series for as long as possible to begin with, then examine the performance measures listed below before making final decisions.

Sharpe Ratio

The Sharpe ratio (developed by W.F. Sharpe) measures risk-adjusted return for a portfolio. It is calculated as the ratio of the excess return (difference between the rate of portfolio return and risk-free rate) and the standard deviation (risk) of the portfolio returns.

The Sharpe ratio is mainly used to tell how well the return of a portfolio per unit of risk taken. Higher Sharpe ration is often associated with higher portfolio returns and/or lower portfolio deviation (risk). In view of this, the greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been.

Return/Drawdown Ratio

As the name implies, this ratio measures the return over the maximum drawdown over a period of time. It can be calculated for different horizons and is a preferred yard stick of short-term traders because the denominator is directly related to ruin. In view of this, the return/drawdown ratio provides a good sense on how much leverage the trader can take without risking a margin call or ruin. For investors with a short investment horizon (say those who are close to retirement) this measure is also relevant.

Efficiency Index Efficient index is the cumulative gain of an investment under the best fixed leverage. The best fixed leverage was first studied by John Kelly related to the information rate in information theory. Thus, the efficiency index measures the intrinsic information implied by an investment strategy. This performance measure is closely related to the compounded return. It complements the Sharpe ratio which is more closely related to simple returns.

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