Top 5 Risk Statistics to Include in Your Factsheets

We all know that investing involves a delicate balance of seizing opportunity and managing risk. Even if you do it well, your factsheet may not adequately explain how your strategy manages that balance. Your factsheets tell the story of your performance history and play a crucial role in your sales process by helping prospective investors make informed investment decisions. But how do you know if you’ve included the right information?

Types of Measurements

While every strategy differs in terms of its investment objective, it’s important to identify which types of statistics will be the best at helping you tell the story behind your investment strategy.

Before you choose the exact statistics to include, take a moment to think through what makes your strategy unique and then consider the audience you’re speaking to (sometimes this may mean making more than one factsheet for the same strategy – think retail vs. institutional).

Here are the main categories that should be included…

• A measure of volatility – to demonstrate stability (or variability) of your strategy
• Correlation – to express sensitivity to the benchmark or market
• Risk-adjusted returns – to standardize performance evaluation when considering risk
• Downside risk – to explain how your strategy performs in down markets
• Market Capture – to display how the strategy performs during market movements (up or down)

Only you know what makes your strategy unique and appealing to prospective investors, so take the time to determine the key pillars of your strategy and then select statistics that help demonstrate or reinforce that story.

Once that’s clear, it’s time to crunch some numbers.

Top 5 Risk Statistics

Here’s a list of the top 5 risk statistics our experts see included on our clients’ factsheets.

1.  A Measure of Volatility: Standard Deviation

Investment managers have different ways of measuring volatility – often dependent on the strategy employed. Most commonly, we see standard deviation used, which is a measure of total risk (i.e., both systematic and unsystematic risk). Standard deviation quantifies the variability of a strategy’s returns from its average over a specific period. A higher standard deviation indicates greater volatility, implying that the strategy’s returns have experienced significant fluctuations or high variability.

Standard deviation is generally presented for both the strategy and a comparable benchmark. Risk-averse investors are generally looking to invest in strategies that achieve higher returns than the comparable benchmark while having a lower standard deviation than the benchmark over the same period.

Be sure to use this measure to demonstrate the stability of your strategy when it is historically low or to attract those with higher tolerance for fluctuation when it has been historically high. An explanation about how that higher fluctuation translates into outperformance will help paint a more complete picture.

2. Strategy Correlation: Beta

When assessing a new strategy, investors often want to consider how the strategy will fit into their broader portfolio. One way to evaluate this is by considering how sensitive the strategy is to the market (or the total portfolio’s benchmark) using beta. When armed with this information, investors can determine if adding your strategy would increase or decrease their exposure to the pulse of the market. If your strategy intends to offer diversification benefits, beta should be less than one (or negative). If you are adding market exposure, it should be greater than one.

In factsheets, we commonly include beta, calculated against the strategy’s benchmark, to show how the strategy moves relative to its benchmark. This is useful for investors to see if the calculated beta aligns with how an investment manager has described its investment process.

For example, for a strategy described as a “bottom-up approach that holds a concentrated portfolio of the best-performing stocks from a larger universe” (and therefore not directly tied to an index), we would expect beta to be very low (or even negative) or very high, but not close to 1. If it is close to 1, they may be a “closet indexer” that claims to have an in-depth research process, uncorrelated with the market, but in reality, is still basically replicating the benchmark. Investors would want to know this because they can invest in ETFs or funds designed to replicate a benchmark for much lower fees.

Conversely, for a strategy that is described as “enhanced indexing,” beta should be close to 1 with returns that outperform the index. In this case, the goal is to track the risk level of the index while beating it performance-wise.

In either case, investors want to see strategy metrics support how your strategy and process is described. If any of these risk measures don’t align, we recommend taking the time to understand and explain why.

3. Risk-Adjusted Returns: Sharpe Ratio

While arguably the most common risk statistic to include, the Sharpe ratio is helpful as a comparison tool because it standardizes performance and risk into one measure.

The Sharpe ratio demonstrates a strategy’s risk-adjusted return by considering its excess return (return above the risk-free rate) per unit of risk taken (standard deviation). A higher Sharpe ratio is preferred. If your strategy claims to offer superior returns with lower risk, the Sharpe ratio is an appropriate measure to demonstrate that.

However, keep in mind that this measure may not be useful for strategies that are not normally distributed (e.g., hedge funds or other strategies with returns that are materially positively skewed when the strategy is successful). For most traditional investment managers, especially those targeting institutional investors, this measure is often expected on a factsheet, so don’t overlook it.

4. Assessing Downside Risk: Maximum Drawdown

Maximum drawdown measures the largest peak-to-trough decline in a strategy’s performance over a specific period. This metric is crucial because it quantifies the potential loss an investor could have experienced during the strategy’s worst-performing period. A larger maximum drawdown implies higher downside risk.

This measure is often good to show along with the max drawdown of the market or benchmark for comparison. While higher potential returns often correlate with greater downside risk, investors, equipped with this information, can determine their tolerance for this kind of loss. In addition, they can use it to compare to other similar strategies they are considering.

If your strategy claims to manage downside risk, maximum drawdown is arguably the best measure to demonstrate tactful management during down markets.

5. Market Capture: Upside/Downside Capture

These measures assess how well a strategy or portfolio performs during market movements, specifically in comparison to a benchmark. Upside capture measures the degree to which a strategy captures the positive returns of a benchmark during periods of market growth. Downside capture measures the degree to which a strategy is exposed to losses when the benchmark declines.

These capture ratios can be used to explain how a strategy aims to achieve specific goals related to market conditions. For example, “beats the market on the upside and protects on the downside” (you’d hope to see over 100% upside capture with less than 100% downside capture) or “capital preservation with risk targets below the overall market” (you’d expect to see lower than 100% upside capture with hopefully a very low downside capture).

Please note that it is most common to show these measures together (or to show total capture ratio that combines the two). Considering the “fair and balanced” requirements in the SEC marketing rule, it’s likely prudent to include both to explain the full picture.

For an aggressive strategy that is over 100% capture both on the upside and the downside or a capital preservation strategy that is under 100% both on the upside and downside, you ideally can still show that the total capture ratio is greater than 1. This demonstrates that the strategy is winning on the upside by a greater amount than it is losing on the downside or that protection on the downside more than offsets the lagging performance on the upside.

Conclusion

When it comes to investing, knowledge is power. Factsheets provide investors with valuable information to help them make informed decisions about your firm and strategies. When you provide them with a full picture of your performance that includes risk, they are more fully equipped to consider you for further due diligence.

Investment firms that understand these statistics and use them to help explain the story of their investment performance provide context and transparency in a saturated landscape of investment options.

Make sure to take the time to understand what these measures say about your performance each period and include that in some form of market commentary when you share your factsheets with prospects. This demonstrates how informed you are about the strategies you manage, how decisions made impact results, and what your plans are to address them.

Want to discuss how you can improve your factsheets with risk statistics? Schedule a free 30-minute brainstorm with one of our partners on which statistics you should include to help explain your investment performance.