Risk-Adjusted Performance Measure

Risk-Adjusted Performance Metric (RAPM)

Explained:

Performance analysis—both prospective and retrospective—plays an important role in business and investing. Consider some examples:

A pension plan has used a particular investment manager to invest its assets for the past five years. They want to perform a retrospective assessment of his performance to determine whether they should keep him for the next five years or replace him with a new manager. Their performance assessment must look at both the returns he has earned for them over the past five years but also the risks he has taken to earn those returns.

A corporation has several business lines it can invest in, but limited resources prevent it from investing in them all. The firm will choose what mix of business lines to invest in based on a prospective assessment of profitability and risk.

An investor is allocating her assets to various asset classes—domestic equities, foreign equities, investment-grade bonds, junk bonds, etc. She chooses an asset allocation based on a prospective assessment of expected returns and risk.

Such assessments must take risk into account. Since a portfolio manager can boost expected returns merely by increasing his systematic risk (beta), performance evaluations must adjust returns for risk. All else being equal, a firm would rather invest in a low-risk business line than one that is equally profitable but more risky. And, obviously, an investor allocating her assets must balance risk against expected returns.

Stated another way, any performance assessment should balance risk and reward. That is what a risk-adjustment performance metric (RAPM) does. A RAPM is a performance metric that assesses reward with some adjustment for risks. What we mean by reward depends on the application. It might be revenues, profits, returns, etc. Similarly, risk might be measured as volatility, beta, value-at-risk, etc.

Various RAPMs are employed in finance. Some were developed during the late 1960s for testing the efficient market hypothesis and are now used by practitioners for asset allocation or performance assessment. These include the Treynor ratio, the Sharpe ratio and Jensen's alpha. Other RAPMs—including ROC and its various RAROC interpretations—were developed during the 1980s and 1990s to support economic capital allocation.