Risk-Adjusted Performance: Why and How it Matters

Some years ago, I was attempting to explain the importance of risk-adjusted performance to a client who was not sure it mattered to them. They stated boldly, “I can’t eat risk-adjusted returns.” Unable to help myself and thinking I was hilarious, I asked whether and how they were able to eat any kind of returns at all. What the client was trying to convey was that they simply cared about increasing the value of their assets. To them, risk-adjusted returns seemed like an academic exercise rather than something that impacted them. Here we seek to illustrate here why risk-adjusted returns should matter to most investors and how they can be placed in context.

Three Reasons Risk-Adjusted Returns Matter

• Markets do not always go up. Carefully considering how much risk was taken in order to earn a return may help investors contemplate what a potential decline in value could look like.
• Investors should prefer the best ratio of reward per unit of risk. Here’s an analogy most people can relate to this time of year — the need to heat our homes. Suppose you have a choice of Furnace A or Furnace B. They produce similar heating output, but Furnace A has a 5% chance of breaking down and needing repairs within 5 years while Furnace B has a 10% chance of needing such repairs. Assuming both furnaces cost the same, we should choose Furnace A for its lower risk. Furnace B invites uncompensated risk. There is no benefit offered to users of Furnace B in exchange for its lower reliability. The same is true for an investment manager that did not produce higher returns despite taking higher risks.
• They may provide a signal about the underlying skill of the investment team. If two investment managers delivered equal returns but one did so with less risk, it could be argued that the manager that took less risk is a better operator. They may have selected investments that delivered better returns for the same level of risk or they may have skillfully diversified the portfolio, selecting investments that complemented one another by performing well at different times, reducing portfolio volatility.

Discussed below are two measures of risk-adjusted returns used to assess investment managers: alpha and information ratio.

Alpha

First some clarification is necessary. Sometimes investment professionals use the word alpha when they simply mean excess returns compared to a benchmark. They might say a portfolio returned 9% while the benchmark returned 8% and therefore, it delivered 1% alpha. But this is not alpha in the risk-adjusted, statistical sense. Alpha as it’s referred to here is risk-adjusted excess returns. Alpha is calculated through a statistical procedure called regression analysis. In the regression analysis, the returns of the investment portfolio are compared to the returns of a benchmark index. Two statistics are calculated: beta and alpha. The beta tells us how sensitive the investment returns are to the benchmark index. The table entitled “How Expected Return Varies with Portfolio Beta” provides a tangible example. If the index advances 10%, an investment with a beta of 0.8 would be expected to advance 8%, all else equal. A beta of 1.2 implies an investment advances 12% when the index advances 10%.

How Expected Return Varies with Portfolio Beta

Disclosure: This is a hypothetical example and is not representative of any specific investment. Your results may vary.

An investment manager has generated positive alpha when its return is higher than would be expected for a given level of beta. An alpha of zero implies that the portfolio performed exactly as expected for its level of market risk assumed. A negative alpha means a manager has underperformed, after taking into consideration the level of beta. The table entitled “Determining Whether Alpha is Positive or Negative” shows hypothetical portfolio betas and portfolio returns. The column called “Excess Return” does not always jibe with the column called “Positive or Negative Alpha.” There are two hypothetical cases where positive returns actually show negative alpha, and there are two hypothetical cases where negative returns actually show positive alpha. This is by design and illustrates how alpha contextualizes performance according to the market risk assumed.

Determining Whether Alpha is Positive or Negative

Disclosure: This is a hypothetical example and is not representative of any specific investment. Your results may vary.

Information Ratio

Information ratio is a way to measure performance compared to “active risk,” risk in comparison to a benchmark index rather than total risk. Information ratio is calculated by taking an investment’s return, subtracting the benchmark index return, and dividing by tracking error. Tracking error is the standard deviation of excess returns — in other words — how volatile the investment is compared to the benchmark index. When measuring an investment portfolio using information ratio, investors are making the assumption that they are comfortable with the risk level assumed by the benchmark index. Any deviations from the index by a manager are viewed as undesirable, unless accompanied by outperformance. Investors using information ratio to judge performance would want to see it positive, as this reflects outperformance, and the higher the better.

While it may be harder to generate excess returns in conservative asset classes, the tracking error also tends to be lower in conservative asset classes. In the “Hypothetical Illustration of Information Ratios,” the first three rows are indicative of what we might observe from outperforming managers in a relatively conservative asset class like investment-grade fixed-income. With each manager having an information ratio of 1.0, the investors may want to let their risk tolerance guide their choice of manager. The bottom three rows may represent outperforming managers in a relatively aggressive equity asset class. Among the bottom three rows, the manager with a 12% return has the best risk-adjusted return.

Hypothetical Illustration of Information Ratios

Disclosure: This is a hypothetical example and is not representative of any specific investment. Your results may vary.

Which Risk-Adjusted Measure is Better?

We would hesitate to answer this definitively. Which metric is most appropriate depends heavily on context, such as which asset class is being evaluated and the investor’s attitude towards risk.

If the investor is comfortable with the risk of the underlying benchmark and wants to hold the manager accountable for deviating from the benchmark, they may prefer to focus on information ratio. The tracking error measure used in the information ratio is concerned with any deviations from the benchmark, regardless of whether they are positive or negative. Thus, investors who are just as concerned about underperformance in an up market as they are about downside participation may want to focus on tracking error and information ratio. Keep in mind, however, that a tracking error of zero implies zero differences with the benchmark — not zero risk — if the benchmark index declines 50%, a manager with 0% tracking error would decline 50%, in lockstep with the index.

Using alpha to judge risk-adjusted performance allows an investor to evaluate the manager in light of the level of market risk they have assumed. This may lead to some unintuitive outcomes, but that is precisely what some evaluators want to tease out, such as an aggressive manager whose outperformance in an up market was not high enough to justify the risk or a conservative manager that did not outperform by as much as expected in a down market.

Keep in mind that beta may understate risk if the manager has taken different types of risk than the benchmark index. For example, a manager that uses a lot of corporate and high-yield bonds may manage against a benchmark index heavily allocated to government bonds and thus show a lower beta (and higher alpha) than expected, because the corporate and high-yield bonds, though volatile, behave differently than the government prevalent bonds in the index.

Important Considerations

• The choice of benchmark is important. Investors who want an apples-to-apples comparison of an investment manager compared to a benchmark index may want to select an index tailored to a particular market segment. For example, a small cap value manager could be compared to the Russell 2000 Value Index. Unfortunately, many data sources available to investors may calculate risk-adjusted returns relative to broad-based benchmarks that may be less applicable to the specific investment.
• Most data sources available to investors are also likely to show alpha and information ratio at a specific point in time, such as the three- or five-year period as of the recent month-end. Unfortunately, this involves begin- and end-point bias, and investors do not have visibility into how the manager’s returns evolved over time.
• Many active managers have style biases, even relative to an appropriate benchmark index. For example, a manager may have a preference for value-priced stocks or companies with high profitability. These biases are sometimes in favor with the market environment and sometimes out of favor.

Why Risk-Adjusted Returns are Especially Important Right Now

2025 was a particularly strong year for risk assets. U.S. equities, as measured by the Russell 3000 Index returned 17.1%. Within U.S. equities, the riskiest stocks generally performed better. When each stock in the Russell 3000 is categorized according to its beta, we see that the highest 20% of beta returned 29.1%. The lowest risk stocks — those in the bottom 20% of beta — returned 11.6%. In other words, in order to outperform the market in 2025, investors generally needed to own higher risk stocks. This is not always the case, at least not to this level of extreme.

Going it Alone?

While measuring risk-adjusted returns is something investors may be able to do on their own, there are many pitfalls they may encounter. Lack of access to appropriate benchmarks, lack of access to rolling periods to avoid begin- and end-point bias, and lack of appreciation of style biases may lead investors to erroneous conclusions about manager performance. Instead, investors can partner with LPL Research, which conducts ongoing monitoring of hundreds of investment managers across mutual funds, exchange-traded funds, and separately managed accounts. Performance evaluation, including risk-adjusted and rolling period analysis, is just part of our process, along with our qualitative assessments related to the investment team and its depth of resources.