18 September 2011

Unit Trust Risk-Return Part 1: The Sharpe Ratio

In any financial investment, risk and return go in parallel. Guaranteed return is known as risk-free return, and almost always refer to either Fixed Deposit rate or Malaysian Government Securities coupon rate. If you are buying government bond such as Greece, it is no longer risk free anyway! FD rate seldom goes beyond 4%; here's a summary of the current risk free rate of return (FD).

Sharpe ratio of an investment refers to how well the investment generates a return taking into consideration the risk. Risk is high when the investment nature has high volatility - tendency for its value to soar or to plunge excessively within a specific timeframe when benchmarked against the overall market activity.

For the mathematically inclined, the equation is as such:

Sharpe ratio for Investment Z = (Investment return for Z - Risk Free Rate of Return) / Standard Deviation for Investment Z

High volatility = High Standard Deviation

Sharpe ratio --> Higher is better. 

Taking Risk Free Rate of Return as constant, 2 factors contribute to higher Sharpe ratio

  • Higher investment return
  • Lower volatility
Let's illustrate this with unit trust examples of the same asset class - Balanced Fund Malaysia.

Notice that Kenanga Growth and AmBalanced has the same risk-adjusted return, 0.68. However, note that Kenanga Growth is more volatile (10.9), therefore the return needs to be higher - 9.7% compared to 7.6% for AmBalanced. 
If you are a above average risk taker, buy Kenanga Growth and bear more risk of larger price NAV price swing at the same time. Else if you are a below average risk taker, AmBalanced is for you.

Next, compare OSK UOB Kidsave with AmBalanced. They have nearly the same volatility, but Kidsave produces significantly higher return at 12%, therefore its Sharpe ratio is double of AmBalanced's.
Logically, Kidsave is a way better investment of choice.

Finally, we compare OSK UOB Kidsave with RHB Capital, which is a Equity Fund Malaysia. RHB Capital produces 14.4% return, marginally higher than Kidsave but naturally with much higher volatility of 15.01. 
The additional risk that comes together with  RHB Capital is not worth the additional 2.4% return compared to Kidsave - as indicated by a lower Sharpe ratio of 0.81

Happy hunting for funds of your choice!

1 comment:

  1. quite a few years back, I did an analysis showing KidSave was great too. Its amazing its still doing ok now.

    This analysis is a point to point assessment, meaning buy at one time and sell at another. If you shift the buy sell period by 1 month, 3 months or even just 1 week sometimes, it 'may' significantly affect these technical parameters.

    Further more, if you practice DCA, then this analysis may not be an apple to apple comparison.

    But still a very impressive analysis :)


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