Adjusted expected risk adjusted return

What Is Adjusted Expected Risk-Adjusted Return?

Adjusted Expected Risk-Adjusted Return is a sophisticated metric within portfolio theory that seeks to refine traditional measures of investment performance. It represents an anticipated future return of an investment or portfolio, accounting for its inherent risk, and then further modifying that assessment based on additional factors. These additional factors can be qualitative, behavioral, or quantitative, aiming to provide a more holistic and personalized evaluation of an investment's attractiveness beyond mere historical performance or statistical volatility. This concept moves beyond a simple historical risk-adjusted return by explicitly incorporating forward-looking views and specific adjustments.

History and Origin

The concept of evaluating investment returns relative to risk gained prominence with the advent of Modern Portfolio Theory (MPT) in the 1950s, which introduced foundational metrics like the Sharpe ratio. These initial models, including the Capital Asset Pricing Model (CAPM), primarily relied on historical data to measure expected return and risk.

However, as financial markets evolved and understanding of investor behavior deepened, the limitations of purely historical and backward-looking metrics became apparent. Academics and practitioners began to seek ways to incorporate more nuanced perspectives. A significant development in this regard was the introduction of multi-factor models, such as the Fama-French three-factor model by Eugene Fama and Kenneth French in 1992. This model expanded CAPM by adding size and value factors to explain stock returns, acknowledging that additional risk premia exist beyond just market risk. The evolution towards "Adjusted Expected Risk-Adjusted Return" is a logical progression, seeking to integrate subjective expectations and various exogenous factors that influence investment outcomes and investor utility, moving beyond the strict statistical confines of earlier models.

Key Takeaways

• Adjusted Expected Risk-Adjusted Return moves beyond historical data, incorporating anticipated future returns and risks.
• It accounts for risks or factors not always captured by basic statistical measures like standard deviation.
• The adjustment component can integrate qualitative considerations or specific investor biases.
• It aims to provide a more comprehensive and tailored view of an investment's appeal.
• This metric is particularly useful for sophisticated portfolio management and specialized investment strategies.

Formula and Calculation

Unlike standardized metrics such as the Sharpe or Sortino ratio, there isn't a single, universally accepted formula for Adjusted Expected Risk-Adjusted Return. Instead, it represents a conceptual framework where existing risk-adjusted return calculations are modified. The core idea involves taking a base expected risk-adjusted return and applying a further adjustment factor.

A generalized conceptual representation could be:

The "Base Expected Risk-Adjusted Return" might be derived from:

Where:

• ( E(R_p) ) = Expected return of the portfolio/asset
• ( R_f ) = Risk-free rate
• ( Risk_Measure ) = A chosen measure of risk (e.g., standard deviation, downside deviation, beta in relation to the market risk premium)

The "Adjustment Factor" is the crucial component that makes this metric "adjusted." This factor could be:

• Behavioral Adjustment: Reflecting investor biases or utility.
• Qualitative Adjustment: Accounting for non-quantifiable benefits or drawbacks (e.g., ESG factors, brand reputation, management quality).
• Market Anomaly Adjustment: Accounting for known market inefficiencies or factors not captured by traditional models (e.g., liquidity premium, size premium).
• Liquidity Adjustment: Reflecting the ease or difficulty of converting an asset to cash.

The nature and magnitude of the "Adjustment Factor" depend entirely on the specific context, objectives, and sophistication of the analysis.

Interpreting the Adjusted Expected Risk-Adjusted Return

Interpreting the Adjusted Expected Risk-Adjusted Return involves understanding that the resulting figure is a tailored assessment of an investment's future appeal. A higher Adjusted Expected Risk-Adjusted Return suggests that, after accounting for anticipated risk and specific contextual factors, the investment is more desirable. Conversely, a lower or negative value indicates reduced attractiveness.

This metric provides context for evaluating investments by moving beyond generic measures. For instance, an investment with a moderate traditional risk-adjusted return might be significantly enhanced by an upward adjustment if it aligns perfectly with an investor's non-financial goals, such as sustainability. Conversely, a seemingly attractive investment might see its Adjusted Expected Risk-Adjusted Return lowered if it carries significant, often unquantified, risks like political instability or poor corporate governance. The interpretation guides decisions in asset allocation, helping investors align their portfolios more closely with their nuanced preferences and broader objectives.

Hypothetical Example

Consider an investor evaluating two hypothetical private equity funds, Fund A and Fund B, both with an estimated 15% annual expected return and similar historical standard deviation suggesting a raw risk-adjusted return of 1.0 (after accounting for a 3% risk-free rate).

Fund A: Focuses on mature, stable businesses with predictable cash flows.
Fund B: Invests in early-stage, disruptive technology companies.

Using a simplistic Sharpe-like calculation, their base expected risk-adjusted returns might appear similar. However, the investor applies an "Adjusted Expected Risk-Adjusted Return" framework:

1. Base Calculation (Simplified):

   • Expected Return (both): 15%
   • Risk-Free Rate: 3%
   • Volatility (estimated future): 12% (for both, for simplicity in base)
   • Base Risk-Adjusted Return = ((15% - 3%) / 12% = 1.0)

2. Applying Adjustments:

   • For Fund A (Stable Businesses): The investor considers its lower liquidity due to private equity structure but also its strong, predictable earnings. The investor applies a small negative liquidity adjustment (-0.05) and a small positive stability adjustment (+0.03).
     • Adjusted Expected Risk-Adjusted Return for Fund A = (1.0 - 0.05 + 0.03 = 0.98)
   • For Fund B (Early-Stage Tech): The investor acknowledges the higher potential for exponential growth (an additional positive factor not fully captured in the 15% expected return due to uncertainty) but also the significant illiquidity and execution risks. The investor applies a larger positive growth potential adjustment (+0.10) and a larger negative risk adjustment for illiquidity and execution (-0.15).
     • Adjusted Expected Risk-Adjusted Return for Fund B = (1.0 + 0.10 - 0.15 = 0.95)

In this hypothetical scenario, even though both funds had similar base expected risk-adjusted returns, the Adjusted Expected Risk-Adjusted Return reveals a nuanced preference based on the investor's specific considerations. Fund A, despite being less exciting, might be preferred by this investor when specific risks and benefits are factored in, as its adjusted value (0.98) is slightly higher than Fund B's (0.95), though the decision ultimately rests on the individual investor's precise interpretation of the adjustment factors.

Practical Applications

The Adjusted Expected Risk-Adjusted Return is employed in various sophisticated financial contexts where a basic historical performance measure is insufficient.

• Hedge Fund and Alternative Investments: These vehicles often involve complex strategies and illiquid assets that require nuanced risk assessments beyond standard deviations. Adjustments might include liquidity premiums, operational risks, or the impact of specific fund strategies like short selling.
• Private Equity and Venture Capital: Valuation in these sectors heavily relies on future projections and specific deal characteristics. Adjustments can account for management team quality, market entry barriers, or unique exit opportunities, enhancing the evaluation of potential alpha.
• Institutional Investing: Large institutions with specific mandates (e.g., pension funds, endowments) may apply adjustments for environmental, social, and governance (ESG) factors, or for specific regulatory requirements that influence the true "value" of a risky asset.
• Client Communication and Compliance: With evolving regulations, such as the SEC's Marketing Rule finalized in 2020, investment advisers must present performance information in ways that are not misleading and incorporate all material factors.³ The framework of an Adjusted Expected Risk-Adjusted Return can help advisors internally evaluate and articulate the rationale behind certain investment choices, even if the final public presentation must adhere to strict guidelines. For instance, the rule allows for the use of hypothetical performance under certain conditions, which aligns conceptually with discussing expected, adjusted returns.²

Limitations and Criticisms

While the Adjusted Expected Risk-Adjusted Return offers a more comprehensive view, it is not without limitations.

• Subjectivity: The primary criticism is the inherent subjectivity in determining the "Adjustment Factor." These adjustments can be qualitative, leading to potential biases or inconsistencies across different analysts or firms.
• Data Challenges: Quantifying future expectations and specific adjustments can be difficult. Reliable data for certain qualitative factors or future market conditions may be scarce or nonexistent, making the "expected" and "adjusted" components prone to estimation errors.
• Over-Optimization and Curve Fitting: There is a risk of "cherry-picking" adjustment factors to make an investment appear more favorable, especially if the adjustments are not rigorously defined or consistently applied. This can lead to models that look good on paper but fail in real-world scenarios. Research Affiliates, for example, has discussed the "Ignored Risks Of Factor Investing," highlighting how factor returns can deviate substantially from normality and how diversification benefits can be overstated, which applies to any overly complex adjustment framework.¹
• Lack of Standardization: Without a universal formula, comparing Adjusted Expected Risk-Adjusted Returns across different investments or managers becomes challenging, limiting its utility as a benchmark.
• Complexity: The added complexity can make the metric less transparent and harder for non-experts to understand, potentially obscuring rather than clarifying investment appeal.

Adjusted Expected Risk-Adjusted Return vs. Risk-Adjusted Return

The distinction between Adjusted Expected Risk-Adjusted Return and a standard Risk-Adjusted Return lies primarily in the forward-looking and comprehensive nature of the former.

While a standard Risk-Adjusted Return provides a factual account of past performance, the Adjusted Expected Risk-Adjusted Return attempts to create a more relevant and predictive measure for future investment decisions by incorporating a wider array of considerations, including those from behavioral finance. The confusion often arises because both aim to balance return with risk, but the "adjusted expected" version acknowledges that simple historical metrics may not fully capture all relevant aspects influencing an investor's true utility or a portfolio's future trajectory.

FAQs

What does "adjusted" mean in this context?

In Adjusted Expected Risk-Adjusted Return, "adjusted" refers to the process of modifying a base expected risk-adjusted return calculation by incorporating additional factors. These factors can be qualitative (like management quality), quantitative (like illiquidity premiums), or behavioral (like an investor's personal biases or aversion to specific types of risk), offering a more tailored assessment beyond typical financial metrics.

Why is it important to use "expected" returns instead of historical?

Using "expected" returns is crucial because past performance does not guarantee future results. While historical data provides insights into past trends, investment decisions are inherently forward-looking. Incorporating expected returns allows investors to base their decisions on their current outlook and projections for future market conditions and asset performance, which is vital for effective diversification and strategic planning.

Does this metric account for all types of risk?

The goal of Adjusted Expected Risk-Adjusted Return is to account for a broader range of risks than traditional metrics. While standard measures focus on quantifiable statistical risks like volatility and beta, the "adjusted" component allows for the inclusion of less tangible risks such as regulatory changes, geopolitical events, or even specific company-level operational risks. However, no single metric can account for all unforeseen risks, and its comprehensiveness depends on the sophistication and completeness of the chosen adjustment factors.