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Adjusting For Risk

From the Bloodhound Exchange.

In each of our results pages for every strategy evaluation, Bloodhound measures returns versus risk. We measure risk by looking at standard deviation of returns (the most common measure). However, not all variance from the mean would be considered "risk" in an investors mind. In common thought, risk is defined as variance from the mean on the down side. In other words, risk equals losing money or underperforming a benchmark. As such, we also look at a measure called Downside Deviation.

Each investor has a certain tolerance for risk, or comfort level for capital erosion. We need not only to evaluate the level of return we hope to achieve, but also the level of risk that is inherent in that investment to achieve such a return. Consequently, when reviewing a strategy's historical performance in Bloodhound, we provide a full page on risk adjusted returns... well as another page on drawdowns (peak-to-trough decline or initial capital level-to-trough decline during a specific period of investment).

Morningstar has their own proprietary measure of risk adjusted return that they use to evaluate mutual funds and ETFs. Unfortunately, they don't disclose how they calculate the measure they call MRaR. However, they do note in the article, There's More to Fund Investing Than Mutual Funds,

Volatility-adjusted measurements of return abound. You really can have your pick. We have the Morningstar Risk-Adjusted Returns (MRaRs), which essentially adjust total returns for volatility and double ding funds for downside volatility (losing money). Research has shown that typical investors are more likely to bail out of funds on downward swings, thus increasing the chances that they may miss out on volatile funds' rebounds--hence the feature in the MRaR.

I took a few items of interest from that article. First, during the past three years, Small Cap Growth ETFs had the highest average return of the major equity categories at 14.24%. However, as one might expect, they also had the highest risk adjustment by Morningstar. The MRaR adjustment drops the risk adjusted average return to 9.62%. On such risk-adjusted basis, Mid-Cap Blend tops the list at 11% average return. Diversified Emerging Market Funds had the lowest absolute average returns. Their risk-adjusted returns were not only also the lowest, but were in fact negative.

In general, in comparable strategies, ETFs outperformed their mutual fund peers. Among equity themes, ETFs outperformed mutual funds by 100 basis points a year over three years. Surprisingly, ETFs gained the most ground in the Large Cap sectors, beating mutual funds by over 2%. The only segments where the mutual funds held the high ground was in the Conservative Allocation and Emerging Markets categories.

On a risk-adjusted basis, ETFs take an even bigger lead. The median ETF category beats its peer mutual fund grouping by almost 2.5%. Mid-Cap Blend ETF strategies had the highest risk-adjusted 3-year return; however, their mutual fund equivalents underperformed by 366 basis points, most of which came in 2010 and 2011.

The Morningstar article highlights a number of other categories including sector funds and fixed income funds. The only one we took particular note in was the Long/Short Equity strategies. The diversity of returns both total and risk-adjusted between mutual funds and ETFs was stunning. Last year, L/S mutual funds put up total returns of a modest 5.15%, yet their ETF peers were down over 9%. Over a three year period, ETFs generated 10% total returns compared to less than 3% for MFs. Yet adjusted for risk, mutual funds focused on long/short equity investment only returned slightly over 1%, but ETFs were adjusted DOWN to less than 6%. In the last three years, ETFs in that category swung from a positive 700 basis point advantage to a 700 basis point disadvantage.

The more investors understand risk - in statistical terms rather emotional ones - the better investors they will become, and in turn, the better annualized returns they can achieve compared to their goals. Morningstar is clearly beating a path towards that educational objective on the mutual fund and ETF side. Although a good first step, we feel investors can actually do better managing the investment process themselves, and Bloodhound gives them the tools to do it.