Risk Adjusted Return 2006_10_16 by yvtong


									                                                    First let’s consider the basic idea of a risk-
Market Monitor                                      adjusted return, which starts with the return a
                                                    stock or a fund has achieved divided by how
TIAA-CREF Asset                                     volatile that return has been over the same time
Management                                          period. Based on long-term history, an
                                                    investment in stocks could be expected to
Brett Hammond                                       potentially return about 9%. So maybe we
Chief Investment Strategist                         should prefer stocks to bonds if bonds are likely
Leo Kamp                                            to return more like 5%. But these figures don’t
Chief Economist                                     take into account relative risk, or how much the
                                                    return bounces around over time. If stocks
Douglas Fore                                        have a volatility or standard deviation of about
Director of Portfolio Analytics                     18% per year and bonds have a volatility of
                                                    only about 10% per year, then their risk-
October 16, 2006                                    adjusted returns are about equal. In other
                                                    words, an expected stock return of 9% divided
    What’s Your Risk-Adjusted Return Ratio?         by a volatility of 18% is 0.5, which is equal to a
                                                    bond return of 5% divided by a volatility of 10%.
When it comes to investments, we all favor high
returns over low returns. That sounds pretty        So let’s take this simple version of risk-adjusted
simple, sort of like saying we prefer more          return and see how it works in practice. Two
money to less money. But the prospect of high       common risk-adjusted return measures are the
returns usually means that you, the investor,       Sharpe ratio and the information ratio, both of
must take more risk in order to get that return.    which were developed by Nobel Prize winner
And that means there is a risk of getting low       William Sharpe of Stanford University. The
returns or even losing money. For example, if       information ratio is purely relative. It measures
you put your money in a basic savings account       the return and risk of a fund relative to its
you won’t lose money, but you likely won’t          benchmark. It does this by taking the
make much. On the other hand, if you put your       difference between the fund’s return and the
money in a higher risk account – say stocks –       benchmark’s return. This is called excess
you could make much more than with a savings        return over the benchmark, or alpha, which can
account but as we all know you could also lose      be positive or negative. It then divides this
money. The point is that the prospect of higher     excess return by the volatility or standard
returns must be tempered by the possibility of      deviation of the excess return, which is also
higher risk.                                        called the fund’s tracking error or active risk.
                                                    So the information ratio is the portfolio’s excess
Our themes today are the following:                 return or alpha divided by its active risk or
                                                    tracking error.
•    The higher the potential investment return,
     the higher the risk of losing money            So how can we interpret an information ratio
•    Risk-adjusted returns are a common and         number or “IR”? The higher the IR the more
     sensible way to compare investment             likely it is that a portfolio manager was able to
     “efficiency” or how much risk is entailed in   take advantage of the available opportunities to
     obtaining the potential return that could be   produce excess return. Some well-known
     achieved                                       thinkers have written that managers with IRs
•    The variety of common risk-adjusted return     that are 0.50 or above are likely to be in the top
     measures ─ including the Sharpe ratio, the     quartile of all managers in their asset class.
     information ratio and the Morningstar rating   That means that the fund enjoys an alpha or
     system ─ each have their own distinct          excess return that is about half of the alpha’s
     features                                       volatility.
          A wrinkle on the IR concept has to do with                               What do these differences mean in practical
          active risk or tracking error. Two funds can                             terms? One is that the Sharpe ratio comes
          have the same overall excess returns relative                            closer than the information ratio to measuring
          to their benchmarks, but have very different                             absolute rather than relative risk-adjusted
          information ratios. Let’s say the excess return                          return. For example, if the S&P 500’s return
          for two funds is 200 basis points, or 2%, but                            falls significantly below the T-Bill rate, then all
          Fund A has an active risk or tracking error of                           or most funds benchmarked to the S&P will
          400 bps or 4%, while Fund B has a tracking                               have negative Sharpe ratios. The second
          error of 800 bps or 8%. So Fund A will have an                           implication has to do with public comparisons.
          IR of 0.50 and Fund B’s IR will be 0.25.                                 Most raters, such as Morningstar, don’t actually
          Clearly, Fund B’s manager is taking more risk                            know what the benchmark is for each of the
          than Fund A’s manager in order to extract the                            funds it tracks. Therefore, Morningstar would
          same amount of alpha from the portfolio. So,                             have a hard time coming up with information
          other things being equal, we’d rather hold Fund                          ratios, which require knowing what the fund’s
          A than Fund B since we can get the same                                  benchmark is. Morningstar does know the T-
          return for less risk.                                                    Bill rate, so it publishes a Sharpe ratio for each
                                                                                   fund it covers.
          Now let’s look at the Sharpe ratio. The Sharpe
          ratio also focuses on return versus risk, but                            In addition, the Morningstar percentile rating
          measures excess return in comparison to a                                system ranks each fund in a category or style
          risk-free rate, such as the 90-day U.S. T-Bill                           box according to Morningstar’s own proprietary
          rate, rather than the fund’s benchmark. The                              risk-adjusted return measurement system. This
          Sharpe ratio also uses the fund’s total volatility                       system penalizes funds that are highly volatile
          or standard deviation over a time period rather                          and rewards low-volatility funds that achieve
          than the volatility or standard deviation of the                         good returns without taking a lot of risk.
          excess returns. So the Sharpe ratio is used to
          compare how fund managers are able to add                                In sum, wise investors care, not just about
          value and take risk over and above a so-called                           returns but also about risk-adjusted returns, or
          riskless investment return.                                              how much risk a fund takes in order to achieve
                                                                                   the returns it enjoys.

TIAA-CREF is a national financial services organization and the leading provider of retirement services in the academic, research, medical and
cultural fields with more than $380 billion in combined assets under management (6/30/06). Further information can be found at www.tiaa-cref.org.

Market Monitor is prepared by TIAA-CREF Asset Management and represents the views of TIAA-CREF’s Investment Strategy and Client Solutions
Group as of October 16, 2006. These views may change in response to changing economic and market conditions. Past performance is not indicative
of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any
product or service to which this information may relate.

TIAA-CREF Asset Management is a division of Teachers Advisors, Inc., a registered investment advisor and wholly owned subsidiary of Teachers
Insurance and Annuity Association (TIAA). TIAA-CREF® personnel in its investment management area provide investment advice and portfolio
management services through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance
and Annuity Association® (TIAA®). TIAA-CREF Individual & Institutional Services, LLC, distributes securities, member NASD/SIPC. TIAA,
TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and FINANCIAL SERVICES FOR THE GREATER
GOOD are registered trademarks of Teachers Insurance and Annuity Association.

Brett Hammond, Leo Kamp and Douglas Fore are available to comment on economic data. If you wish to speak with them, please contact Chad
Peterson, Media Relations, 212-916-4808 or email cpeterson@tiaa-cref.org.

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