Investors have long been interested in assessing fund manager performance. It was initially measured by comparing the total returns of a managed portfolio with those of an unmanaged portfolio chosen at random (the 'dartboard' portfolio). The concept of efficiency was later introduced, and managers were benchmarked against the unmanaged 'market'. More recently, benchmarks have been revised to reflect more closely the investments relevant to the fund manager under evaluation.

While the benchmarks for comparison have improved, investors continue to focus almost exclusively on a portfolio’s total return. Yet this is an incomplete measure of a portfolio’s performance because it ignores risk.

Consider risk when measuring performance

The reason that risk is such an important metric to consider when measuring performance is simple. Consider what drives millions of South Africans to shell out their hard-earned money on lottery tickets every week when the chances of winning are almost nothing? The answer is intuitive — the chance of an extraordinary return. R1-million for R3 invested, in other words a total return of 333 333 percent. Looking at this same example from a different angle, if the potential lottery payout was only R100 000 would we buy as many lottery tickets? Logic suggests not as the reward simply does not justify the probability of success. (It is important to note that buying lottery tickets is not investing, but rather a form of gambling, with the odds of winning heavily stacked against one.)

Nevertheless, this activity is a real-life example of the risk-reward trade-offs that exist in our everyday lives as well as being one of the cornerstones of modern portfolio theory.

Put simply, investors like positive returns, but they try to avoid risk.

The risk/return trade-off

A freely-traded market reflects this principle in the pricing of investments: strong demand for safer investments drives their prices higher (and their return proportionately lower), while weak demand for riskier investments drives their prices lower (and their potential return higher). It is a fund manager’s responsibility to recognize this trade-off.

Some investors can tolerate more risk than others and although this is out of the fund manager’s control it is up to the manager to maximize the level of return, working within the risk constraints of the individual investor which can vary greatly. The appraisal of a fund manager can therefore never be accurately assessed by focusing on total return alone. Unfortunately this is a common mistake.

Investors can use numerous ratios to compare funds on a risk-adjusted basis, allowing for a more accurate comparison between funds. The logic underlying them all is very similar: the ratios look at the return produced by an investment and then penalizes that return based on the risk the fund manager exposed the fund’s investors to.

High returns doesn't equal good management

There are many definitions for risk, but in finance risk is the probability that an investment's actual return will be different to that expected. This includes the possibility of losing some or all of the original investment and is measured by standard deviations. High returns no longer automatically suggest good management if the risk the fund manager undertook could have been reduced to achieve similar results!

Our heightened consideration for risk stems from the fact that the majority of our investors are retired.

We aim to reduce the financial anxiety of the retired investor through an Income Focused Investment style. This style is based on a business truth that the value of a company grows over time at the rate at which its profits grow. In the same way, the value of an investment, over time, grows at the rate its dividends grow. By purchasing securities that produce reliable income streams (ideally growing) at the appropriate price, we have a number of funds that have been able to produce significantly above average risk adjusted returns.

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