No Pain, No Gain: Putting Risk-Adjusted Returns in Perspective

Data Insight Summary:

  • 2018 was a year characterized by negative returns and elevated market volatility across nearly all global markets, except for cash and short-term bonds. Was 2018 a short-lived blip? Or, was it a turning point in the longer-term trend of risk-adjusted returns?

  • To get some answers and gain a better perspective, we analyzed the past 30 years of risk-adjusted returns on a standard 60/40 portfolio (i.e. 60% U.S. equities and 40% U.S. bonds). (Note: Risk-adjusted returns are measured by the trailing 10-year average Sharpe Ratio.)  

  • What we found is that 2018 actually exhibited relatively average levels of market volatility compared to historical market environments, while the past 10 years have been characterized by some of the more elevated Sharpe Ratios in recent decades, as depicted in Figure 1 below.

  Figure 1:  Rolling 10-Year Average 60/40 Portfolio Sharpe Ratios

Source: Norgate Premium Data, RQA

Source: Norgate Premium Data, RQA

  • Given the fact that the last 10 years have encompassed the entire recovery period since the lows of the financial crisis, it is not surprising that risk-adjusted returns have risen dramatically.  When markets recover and a bull market sets in, returns are often generated with relatively limited volatility, leading to an increase in risk-adjusted returns overall.  As such, with the exception of 2015 and 2018, it has arguably been a very smooth ride for those employing an index-based 60/40 approach or something similar. 

Implications Going Forward:

  • So what does this mean for investors over the next 10 years?  Is this time different?  Are we in a new paradigm characterized by above average risk-adjusted returns for the foreseeable future?  Or, will there likely be some reversion back to the historical averages over the next decade?

  •  Based on a historical regression analysis of 10-year average Sharpe Ratios and the subsequent 10-year returns from the 60/40 portfolio, as depicted in Figure 2 below, we find that there is a mean-reverting tendency over longer time horizons – i.e. above average Sharpe Ratios tend to precede low or negative future returns over the long run, and vice versa.

Figure 2:  10 Year Historical Sharpe vs. 10 Year Forward Return (60/40)

Source: Norgate Premium Data, RQA

Source: Norgate Premium Data, RQA

  •  As detailed in the chart above, we can note that as the 10-year historical Sharpe Ratio (x-axis) increases, the 10-year forward returns (y-axis) of the 60/40 portfolio tend to decline. This phenomenon can largely be attributed to the long-term mean-reverting nature of markets in general – hence one of the primary reasons Warren Buffett-style value investing has worked so well over time.  In other words, periods where returns persistently exceed long-term averages are typically followed by periods of underperformance.  Moreover, periods of positive returns are also typically characterized by lower volatility, while periods of decline generally experience much higher levels of volatility and downward shocks, exacerbating the downward pressure on risk-adjusted return metrics like the Sharpe.

  •  So what can we conclude from the most recent Sharpe Ratio calculations?  As it relates to the returns of U.S. equities or the 60/40 portfolio in the near-term - not a lot - as markets in the near-term can continue in any direction for a number of years, regardless of any technical or fundamental rationale.  From a longer-term perspective, however, we can use this data snapshot as a blunt tool to measure where markets stand relative to their history and direct our portfolio expectations, accordingly. 

  Concluding Thoughts:

  •  After reviewing and analyzing the dynamic nature of risk-adjusted returns over time, particularly through the lens of the Sharpe Ratio, we are reminded of just how smooth our ride has been over the past decade (although it doesn’t necessarily feel like it).  Given the backdrop of U.S. equity outperformance in the last 10 years and significant valuation discrepancies compared to non-U.S. equity markets, we continue to believe in the prudence of seeking maximum diversification across global asset classes, such as domestic and international stocks, bonds, and alternatives like commodities and real estate.  Additionally, we firmly believe that investors can and should enhance their portfolio’s diversification and risk management capabilities by diversifying across a spectrum of both passive and active investment strategies (i.e. diversifying across diversifiers) - something we call multi-dimensional diversification.

  •  At RQA, we take an evidence-based, systematic approach to investing, as it allows us to remain objective about the markets and alleviate any psychological pitfalls that many succumb to in more difficult market environments.  As we make our way forward, we maintain our view that the best path any investor can take is to continually seek out maximum portfolio diversification and rigorous risk management in order to optimize the balance between portfolio growth and protection throughout market cycles.

Disclaimer: These materials have been prepared solely for informational purposes and do not constitute a recommendation to make or dispose of any investment or engage in any particular investment strategy.  These materials include general information and have not been tailored for any specific recipient or recipients.  Information or data shown or used in these materials were obtained from sources believed to be reliable, but accuracy is not guaranteed.  Furthermore, past results are not necessarily indicative of future results. The analyses presented are based on simulated or hypothetical performance that has certain inherent limitations.  Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight.