ETF/Fund Research Thread - Learning to Fish - Analytics Available

[COcheesehead]

I thought I would start a learning thread on some of the analytics available to DIY investors for researching ETF and funds. I look at it as teaching someone to fish vs being given the fish.

These analytics are available from most brokerages and other financial sites. The use of screening tools allows you to sort on these numbers to find investment candidates that may appeal to you.

Sharpe ratio
The Sharpe ratio is a measure of historical risk-adjusted performance. It is calculated by dividing the fund's excess returns (the fund's average annual return for the period minus the 3-month "risk free" return rate) and dividing it by the standard deviation of the fund's returns. The higher the ratio, the better the fund's return per unit of risk. The three month "risk free" rate used is the 90-day Treasury Bill rate. Over 1 is good, over 2 is rare, over 3 is phenomenal.
For comparison the S&P has a 1.25 for the past year. .8 for the last ten years.

Beta
A measure of a portfolio's sensitivity to market movements (as represented by a benchmark index). The benchmark index has a beta of 1.0. A beta of more (less) than 1.0 indicates that a fund's historical returns have fluctuated more (less) than the benchmark index. Beta is a more reliable measure of volatility when used in combination with a high R2 which indicates a high correlation between the movements in a fund's returns and movements in a benchmark index. The S&P’s beta is 1.00

R2
A measurement of how closely the portfolio's performance correlates with the performance of the fund's primary benchmark index or equivalent. R2 is a proportion which ranges between 0.00 and 1.00. An R2 of 1.00 indicates perfect correlation to the benchmark index, that is, all of the portfolio's fluctuations are explained by performance fluctuations of the index, while an R2 of 0.00 indicates no correlation. Therefore, the lower the R2, the more the fund's performance is affected by factors other than the market as measured by that benchmark index. An R2 value of less than 0.5 indicates that the Annualized Alpha and Beta are not reliable performance statistics.
The S&P’s R2 is 1.00

Standard Deviation
Statistical measure of how much a return varies over an extended period of time. The more variable the returns, the larger the standard deviation. Investors may examine historical standard deviation in conjunction with historical returns to decide whether an investment's volatility would have been acceptable given the returns it would have produced. A higher standard deviation indicates a wider dispersion of past returns and thus greater historical volatility. Standard deviation does not indicate how an investment actually performed, but it does indicate the volatility of its returns over time. Standard deviation is annualized. The returns used for this calculation are not load-adjusted.
S&P’s 1 year is 10.29. 10 year is 14.99


To meet my investment goals I look for high Sharp ratios and low volatility. You’ll find as these numbers reach extremely positive outcomes, the pool of candidates becomes pretty small and those are the investments I seek.

Fidelity for example displays these numbers in a nice little box for each investment, but they are also available displayed in columns on screening tools so you can sort on these analytics.

 

[BlueberryPie]

Expense ratio (ER) is a big one: how much are you paying to the fund out of the earnings. It's their operating cost and other fees expressed as a percentage.
The metrics above are always expressed after fees when dealing with reputable sites (and not so when dealing with financial advisors that promise you the moon)
Almost by definition, you should expect to earn the index minus the expense ratio for a fund that perfectly follows an index.
For actively managed funds, it gets more murky, but the find has to perform it's index by at least it's expense ratio to max out the index.

 

[LTSTRYAGIN]

Thank you Cocheese for starting this thread much appreciate
today as mentioned above many new tools being much improved every day e.g. (coaching classes at Schwab) good stuff for those who want to understand how to fish like myself
Trader Talk courses fundamentals w/ some chart education ...Good stuff ... correlation of earnings to price movement how to use the tools to spot bullish patterns

 

[COcheesehead]

Expense ratio (ER) is a big one: how much are you paying to the fund out of the earnings. It's their operating cost and other fees expressed as a percentage.
The metrics above are always expressed after fees when dealing with reputable sites (and not so when dealing with financial advisors that promise you the moon)
Almost by definition, you should expect to earn the index minus the expense ratio for a fund that perfectly follows an index.
For actively managed funds, it gets more murky, but the find has to perform it's index by at least it's expense ratio to max out the index.

Expense ratios are tricky. If equal outcomes are likely such as an index based fund, you chose the one with the lowest expenses. If proprietary strategies are used, AQR family of funds for example, the outcome is all that matters.
An example is QHMNX. It has an expense of 4.67%. A passive index investor would faint over that high of an expense, but the fund has returned AFTER expenses 18.26% YTD.

 

[OldShooter]

Volatility is well-entrenched in investing folklore as being correlated with risk. Think SD, Sharpe Ratio, etc. I have never, however, seen a credible argument that this correlation exists. To me risk is things like Sears, Enron, General Electric, Worldcom, Kodak, etc. The economists would love to have a quantitative measure of risk, though, so in desperation they have latched on to volatility.

Re Expense Ratio that is indeed the big one. Morningstar studies have repeatedly said that low ER is the best (and maybe the only) predictor of higher fund performance.

 

[joejetski]

Good morning Shooter,
As a general matter, I agree with you that these are all cautionary tales of idiosyncratic risk, but only Worldcom and Enron stand out as companies where investors had little to no chance to bail out due to fraud allegations. One of my mother’s friends fell victim to the Enron scandal.

 

[OldShooter]

Good morning Shooter,
As a general matter, I agree with you that these are all cautionary tales of idiosyncratic risk, but only Worldcom and Enron stand out as companies where investors had little to no chance to bail out due to fraud allegations. One of my mother’s friends fell victim to the Enron scandal.

Agreed. It was sloppy work to list those two as they are not typical. My point is the same, though. Volatility is NOT risk. (Except SORR, which can be dealt with separately.)

 

[Lorenzo]

I saw @COcheesehead 's original post a few weeks ago, and it was timely for me, as I had just been looking up Sharpe Ratio, Sortino, etc., to try to understand what these are, as the terms are used frequently in the Active Investing threads. I was reminded I hadn't yet posted my thoughts here by @Semi-Retyrd's comment in the Why I Like Certain Alternative Investments thread that HOSIX's Sharpe ratio is "unusually high partly due to structural design." I would like to get a handle on Sharpe ratio and related measures of risk-adjusted return.

I have been grappling with what standard deviation--the denominator in the formula--is intended to inform about. "Risk"? Isn't standard deviation a measure of volatility? How is one to understand the historical risk-adjusted performance of a security that has convulsed up and down yet climbed and climbed on average for years? "Risk" means risk of losing money, right? Should one look at the Sharpe ratios of crazy-growth stocks like Nvidia differently than the Sharpe ratios of mutual funds/ETFs? It seems to me that with something like Nvidia, the numerator in the formula--the excess return above the risk-free return level--is so high that it masks or damps the information the denominator is intended to contribute, rendering the calculated Sharpe ratio less meaningful to an investor.

It seems to me one should reduce in their mind the risk-adjusted return of a stock like Nvidia by the probability one believes of Nvidia's return collapsing in an amount of time that is short compared with how long it has been on the upward trend. In other words, I would think "risk" (of losing money) is more related to sudden collapse from a comparatively long upward trend than related to short term convulsions (as measured by standard deviation). Or to put it more succinctly, the less you believe a security is of a type that might be susceptible to sudden collapse, the more faith you might have in its calculated Sharpe ratio.

Anyone?

 

[COcheesehead]

I have been grappling with what standard deviation--the denominator in the formula--is intended to inform about. "Risk"? Isn't standard deviation a measure of volatility?
Anyone?

It is exactly a measure of volatility.

Here is what I wrote in my OP.

Standard Deviation
Statistical measure of how much a return varies over an extended period of time. The more variable the returns, the larger the standard deviation. Investors may examine historical standard deviation in conjunction with historical returns to decide whether an investment's volatility would have been acceptable given the returns it would have produced. A higher standard deviation indicates a wider dispersion of past returns and thus greater historical volatility. Standard deviation does not indicate how an investment actually performed, but it does indicate the volatility of its returns over time.

 

[Lorenzo]

Yes, that is also what I read in sources I found. Here it is phrased as "investors may examine historical standard deviation in conjunction with historical returns to decide whether an investment's volatility would have been acceptable given the returns it would have produced." Yet the calculated Sharpe ratio that is the "in conjunction" part is described as "historical risk-adjusted performance." How does an investment's volatility relate to risk of an investment losing money?

I'm thinking aloud here: There has to be a time element to risk. Over the same investment time horizon, a more volatile investment would be riskier than a less volatile investment of the same return. Maybe the time element is hidden in the returns and standard deviation: if they are measured over the same time period then the time element cancels itself out? I'm trying to understand why it should matter to the investor's examination of risk whether an investment marches steadily upward over some time period or convulses up and down over that period like a bucking bronco while it, on average, provides the same returns over the same time period? An investment is risky if you are likely to have to sell it while it's down, and the probability is higher that a higher volatility investment will be down when you sell it. Aha! Maybe my buy-and-hold bias is showing here; I think of risk in terms of time in the market. I'd like to temper that bias by better understanding the risk-adjusted return concept. And maybe I've answered my own question in my "thinking aloud" above.

 

[COcheesehead]

Yes, that is also what I read in sources I found. Here it is phrased as "investors may examine historical standard deviation in conjunction with historical returns to decide whether an investment's volatility would have been acceptable given the returns it would have produced." Yet the calculated Sharpe ratio that is the "in conjunction" part is described as "historical risk-adjusted performance." How does an investment's volatility relate to risk of an investment losing money?

I'm thinking aloud here: There has to be a time element to risk. Over the same investment time horizon, a more volatile investment would be riskier than a less volatile investment of the same return. Maybe the time element is hidden in the returns and standard deviation: if they are measured over the same time period then the time element cancels itself out? I'm trying to understand why it should matter to the investor's examination of risk whether an investment marches steadily upward over some time period or convulses up and down over that period like a bucking bronco while it, on average, provides the same returns over the same time period? An investment is risky if you are likely to have to sell it while it's down, and the probability is higher that a higher volatility investment will be down when you sell it. Aha! Maybe my buy-and-hold bias is showing here; I think of risk in terms of time in the market. I'd like to temper that bias by better understanding the risk-adjusted return concept. And maybe I've answered my own question in my "thinking aloud" above.

It seems like you are questioning the calculation of the Sharpe ratio, no?
It’s a comparison tool and not the only one, but a good one.

 

[winyaz]

I think the simple answer is that a high Sharpe or Sortino ratio describes the past. They do not necessarily predict the future and so as investors, we have to decide if we think the future will look like the past or could it be dramatically different. I don't know what will happen with NVDA, but SMCI may be a good example of the concern. On a 5 year chart it went from around 3.50 to 122. I imagine it had a very high sharpe and sortino ratio at that point in time. It then proceeded to drop 85%. While I agree with OldShooter that Volatility does not equal risk, I do think that it represents a component of risk. In my experience, stocks, funds, or strategies that have high volatility upward, are capable of high volatility downward. The converse is not necessarily true. Stocks that have low volatility upward are not necessarily incapable of higher volatility downward. Take HOSIX for example. I read up on it briefly and put it into Portfolio Visualizer to see it's Sortino ratio - over 10! Apparently they buy shorter term lower quality debt that is free floating and so immune to the risks of rising interest rates. What they are probably not immune to is the risks of lower quality debt - if there is a recession (I think odds are currently running about 20%) and some of the companies behind that debt have financial issues, I think that smooth chart could change quite suddenly, or maybe they are well enough diversified to absorb that in stride - I really have no idea. But it is a risk not accounted for in the Sortino or volatility. Take another example: USMV. A fund based on minimum volatility stocks. In this case I think the lower volatility does reflect lower risk of decline. While some components may have a structural breakdown, like Enron or whatever, I think that is unlikely across the portfolio. So the lower volatility may in fact predict lower future risk. And I am speaking specifically to the risk of exceeding the market to the downside, rather than the risk of underperforming on the upside - which it generally does.

 

[COcheesehead]

Sharpe’s are calculated over different time horizons too. I look for big gaps. That’s a tell as well.

 

[COcheesehead]

For those scratching their head on Sortino ratio…

 

[COcheesehead]

HOSAX is a 10. Wild.