The trade off all investing is built on
He also has a key financial measure, the Sharpe ratio, named after him. The Sharpe ratio compares the excess return on an investment with the volatility of an investment – a way of looking at the link between return and volatility.
The Profound Relationship Between Risk and Return
The capital asset pricing model and the Sharpe ratio were both a product of the 1960’s, with a focus on the relationship between investment risk and return. While investment risk can be described in different ways, in terms of owning shares it is often talked about in terms of volatility. Cash, comparatively, is a less volatile investment – it has known and steady returns. Shares, on the other hand, will have periods of above average returns and, as we are seeing now, periods when they fall in value.
An Example of the Risk – Return Trade-off
This trade-off between risk and return is not just theoretical, it is possible to observe it in real life. Let’s consider 3 different portfolios:
1 Portfolio is 100% cash
1 Portfolio is 50% cash and 50% shares (a balanced-style portfolio)
1 Portfolio is 100% shares
By looking at these three portfolios where the cash rate is 5%, and the return from shares varies from 25% (good year) to 10% (average year) and -5% (poor year), we can see the way returns are linked to the amount of risk, in this case exposure to shares, taken on by the portfolio.
In the table below, we have used the spread of returns as a measure of the volatility of a portfolio.
Table 1: Theoretical Portfolio Returns for Portfolios with Varying Asset Allocations
|
Return in a Good Year Cash = 5% Shares = 25% |
Return in an Average Year Cash = 5% Shares = 10% |
Return in a Poor Year Cash = 5% Shares = -5% |
Spread of Returns |
100% cash |
5% return |
5% return |
5% return |
0% |
50% cash 50% shares (Balanced Portfolio) |
15% return |
7.5% return |
0% return |
15% |
100% shares |
25% return |
10% return |
-5% return |
30% |
200% shares -100% cash (borrowing at 7%) |
42.5% return |
12.5% return |
-17.5% return |
60% |
We can also create a 4th portfolio, one that has doubled their portfolio by borrowing (ie a $10,000 portfolio borrows another $10,000 to give $20,000 worth of market exposure) at the rate of 7.5% (a margin above the cash rate). This increases the possible return of the portfolio – in a ‘normal’ year a 10% return from shares becomes a 12.5% return (10% x 2 -7.5% borrowing cost) for the portfolio, while also increasing the volatility of returns – the 25% share return in a good years becomes and exciting 42.5% return, and the -5% return in a poor year becomes a -17.5% return for the portfolio after the poor return and interest costs are taken into account.
The Impact of Fees for Investors
If this profound investment relationship holds – that there is a trade-off between risk and return with higher returns requiring an investor to take on higher risk – it starts to become evident that the fees we pay as investors are crucial, because if we pay too much in fees, that will decrease the returns of a portfolio while keeping the spread of returns the same.
Consider our ‘balanced’ share portfolio. A fee of 0.5% per annum across the portfolio will see a return of 14.5% after fees in a good year, 7% after fees in an average year and -0.5% per year in a poor year. The spread of returns stays the same (15%), but the return in each situation is reduced. This is not a huge deal with a 0.5% fee, but with a 2% fee – and there are plenty of fund managers charging 2% for a balanced fund – and it becomes more significant.
Bill Sharpe’s Contributions on the Subject
This brings us very nicely to two important contributions that Bill Sharpe has made in discussing fees. The first one is a theoretical discussion of market returns, from an article titled, ‘The Arithmetic of Active Management’. He splits the overall sharemarket into two parts, those who use an index approach (the minority of the market), and those who are active. Let’s say the overall average return from the market is 10%.
Those using an index approach will receive a return of 10%, less the small fees from an index/ETF style investment.
The remaining average on the active part of the market must also be 10%. However, this is the part of the market where people have spent more money to invest – paying more for research, fund managers and more regular trading. Sharpe explains:
"Because active and passive (index style) returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management."
Later in the article he restates this finding:
"To repeat: Properly measured, the average actively managed dollar must underperform the average passively (index) managed dollar, after costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
A second contribution, around the impact of investment fees, contains valuable information. From the 2013 paper titled, ‘The Arithmetic of Investment Returns’ (Link: The Arithmetic of Investment Expenses by William F. Sharpe :: SSRN), he found choosing a low fee investment option could produce a 20% higher standard of living for investors in retirement.
It is interesting to see someone whose life has been involved in the theoretical analysis of investment returns, starting back in the 1960’s with CAPM and the Sharpe ratio, turning his mind to the very real challenge of a retirement ‘standard of living’.
Conclusion
There is a fascinating journey of Bill Sharpe’s work, starting with the consideration of the relationship between risk and return in investments, and finishing with important contributions around the impact that fees play on investment returns and, ultimately, the standard of living we experience in retirement. If there is a relationship between risk and return from investing, and many would describe that as THE profound investment relationship, then in pays to ensure that your investment fees are modest.
Frequently Asked Questions about this Article…
The Sharpe ratio is a key financial measure that compares the excess return on an investment with its volatility. It's important for investors because it helps them understand the relationship between risk and return, allowing them to make more informed investment decisions.
The risk-return trade-off is a fundamental concept in investing, where higher potential returns come with higher risk. Understanding this trade-off helps investors choose the right balance of risk and return for their portfolios, whether they prefer stable returns from cash or higher, more volatile returns from shares.
Different portfolios offer varying returns based on their asset allocation. For example, a 100% cash portfolio offers steady returns, while a 100% shares portfolio can yield high returns in good years but may also incur losses in poor years. A balanced portfolio of 50% cash and 50% shares offers moderate returns with moderate risk.
Investment fees can significantly impact portfolio returns by reducing the overall return. For instance, a balanced portfolio with a 0.5% fee will see reduced returns compared to a fee-free scenario. Higher fees, such as 2%, can further decrease returns, making it crucial for investors to consider fees when choosing investment options.
Active investment management involves frequent trading and higher costs for research and fund management, while passive management, like index investing, typically incurs lower fees. According to Bill Sharpe, after accounting for costs, passive management often outperforms active management in terms of net returns.
Choosing a low-fee investment option can significantly enhance an investor's standard of living in retirement. Bill Sharpe's research suggests that lower fees can lead to a 20% higher standard of living, making it a crucial consideration for long-term financial planning.
Borrowing to invest can amplify both returns and risk. For example, doubling a portfolio by borrowing can increase returns in good years but also magnify losses in poor years. This strategy increases the volatility of returns, making it suitable only for investors comfortable with higher risk.
Bill Sharpe has made significant contributions to understanding investment fees, highlighting that active management often underperforms passive management after costs. His work emphasizes the importance of considering fees in investment decisions to maximize returns and improve retirement outcomes.