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Using Risk-Adjusted Return

Introduction

Risk-adjusted return either shifts the risk (which is the standard deviation of returns) of a portfolio to match the risk of a market portfolio or shifts the risk of a market portfolio to match the risk of a fund. According to the Capital Asset Pricing Model (CAPM), the market portfolio and a riskless asset are points on a Security Market Line (SML). The return of the resultant shifted portfolio, levered or unlevered, to match the risk of the market portfolio, is the risk-adjusted return. The SML provides another measure of risk-adjusted return, since the difference in return between the fund and the SML, return at the same level of risk.

Risk-Adjusted Return

Given our example data with a fund, a market, and a cash series, you can calculate the risk-adjusted return and compare it with the fund and market's mean returns

load FundMarketCash 
Returns = tick2ret(TestData);
Fund = Returns(:,1);
Market = Returns(:,2);
Cash = Returns(:,3);
MeanFund = mean(Fund)
MeanMarket = mean(Market)

[MM, aMM] = portalpha(Fund, Market, Cash, 'MM')
[GH1, aGH1] = portalpha(Fund, Market, Cash, 'gh1')
[GH2, aGH2] = portalpha(Fund, Market, Cash, 'gh2')
[SML, aSML] = portalpha(Fund, Market, Cash, 'sml')

which gives the following results:

MeanFund =

    0.0038

MeanMarket =

    0.0030

MM =

    0.0022

aMM =

    0.0052

GH1 =

    0.0013

aGH1 =

    0.0025

GH2 =

    0.0022

aGH2 =

    0.0052

SML =

    0.0013

aSML =

    0.0025

Since the fund's risk is much less than the market's risk, the risk-adjusted return of the fund is much higher than both the nominal fund and market returns.

See Also

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