Top Five Risk Statistics for 2024

Despite all the uncertainties and obstacles investors faced in 2023, such as the regional banking crisis, the debt ceiling standoff, conflict in the Middle East and monetary policy uncertainty, the S&P 500 index defied expectations and posted a strong 26.29% return. While investors looked past the uncertainties to support the strong equity rally, it’s important to remember that investment risk never goes away.

As we make our way through 2024, it’s a good time to revisit our favorite risk statistics that will help financial advisors locate investment managers who optimize return per unit of risk and do a good job of preserving the hard-earned gains since the pandemic drawdown. Below are five risk statistics that we feel financial advisors should consider when conducting manager due diligence in 2024. By leveraging Zephyr's three decade long history of being a leader in portfolio analytics, we have compiled five risk statistics that we feel financial advisors should consider when conducting manager due diligence in 2024.

• Pain Index, which is a Zephyr proprietary risk metric, attempts to measure the complete scope of losses. It quantifies the capital preservation tendencies of a manager or index. The pain index measures the depth, duration, and frequency of all periods of losses. Furthermore, it addresses the shortcoming of only looking at the maximum drawdown and measures risk in terms of absolute returns.
  
  We often talk about how it’s important to win by not lossing. The pain index quantifies all periods of losses for an investment. During times of high volatility, like we experienced in 2020, it is important to reduce drawdown risk. Achieving investment goals is just as dependent on minimizing losses as maximizing gains. The pain index is a very valuable metric that should be considered regardless of the client’s risk tolerance. A pain index of zero means an investment never lost value and represents the best possible outcome. The client would prefer 1) smaller overall losses, 2) shorter periods of loss, and 3) infrequent losses. All three would translate into a lower pain index which is preferable.
  
  
• Pain Ratio is another Zephyr proprietary return-versus-risk trade-off metric. While one certainly wants to minimize losses, it is also important to make money. The pain ratio quantifies this trade-off into a single number. The pain ratio compares the gains over the risk-free investment against the losses that were suffered to obtain that return. The pain ratio compares the added value over the risk-free rate against the depth, duration and frequency of losses. If this definition sounds familiar to you, it should. The pain ratio is similar to the granddad of all return-vs-risk trade-off metrics, the Sharpe ratio. The difference lies in how the metrics measure risk. The pain ratio focuses on capital preservation by measuring risk as the depth, duration and frequency of losses (pain index), whereas the Sharpe ratio focuses on volatility and uses standard deviation as its preferred measure of risk.
  
  We prefer the pain ratio to other return-versus-risk trade-off statics like the Sharpe ratio because of how it looks at investment risk. We view investment risk as how much money can I lose versus how volatile an investment is. Because of this view, we focus more on metrics that quantify the manager’s ability to limit drawdowns or losses, which is exactly how the pain ratio measures risk: the depth, duration and frequency of all losses.
  
  
• Tracking Error does a great job of measuring two return characteristics of a manager. First, tracking error measures how consistently a manager outperforms or underperforms the benchmark (excess return). It is created by taking the difference between the manager return and the benchmark return every month or quarter and then calculating how volatile the difference is (standard deviation of excess returns). Second, tracking error is useful in determining how “active” a manager’s strategy is. The lower the tracking error, the closer the manager follows the benchmark. The higher the tracking error, the more the manger deviates from the benchmark.
  
  There are a lot of things in the investment world that are uncertain, and that is why finding a manager who consistently outperforms is so important. Tracking error does a good job of showing if a manager makes big bets away from the benchmark and if those bets pay off or not, again, it shows how “active” a manger’s strategy is. A client who is in the later stages of his or her investment journey may not want their managers to make big wagers, particularly if those wagers turn out to be on the wrong side. On the flip side, a client in the early stages of their journey may want a very active manager, particularly if those big wagers translate into larger outperformance compared to the benchmark.
  
  
• Information Ratio is a benchmark-relative return-vs-risk metric that measures the excess return against the benchmark divided by tracking error, where tracking error is a measure of consistency. The higher the information ratio, the better. If the information ratio is less than zero, it means the active manager failed on the first objective of beating the benchmark. The information ratio is a fantastic way to justify an active manager’s existence. It covers the two things you as an investor want to see from an active manager. 1.) You want to see the manager outperform and add value over a passive benchmark, and 2.) you want the outperformance to be consistent.
  
  There are a lot of investment options a financial advisor can choose from. One of them is actively managed mutual funds. We like the information ratio because it helps determine if an active manager is rewarding investors by consistently beating the passive benchmark, which you want to see since you are paying higher fees. If your manager is producing a relatively low information ratio, i.e. not producing consistent excess returns to offset the fees, it may be time to either change managers or use a passive investment in its place. With uncertainties regarding geo-politics, monetary policies, and the health of the U.S. economy, employing a manager who provides consistent excess returns is very welcoming.
  
• Downside Deviation is a risk statistic measuring volatility. It is a variation of standard deviation that focuses only upon the “bad” volatility. Downside deviation addresses the shortcoming of standard deviation, which makes no distinction between the “good”, or upside deviations, and the “bad,” or downside deviations. Both upside and downside deviations have an equal influence on the calculation of standard deviation. Downside deviation seeks to remedy this by ignoring the “good” observations and by instead focusing on the “bad” returns.
  
  As we mentioned above, we look at investment risk as how much money can I lose rather than focusing on the volatility of the entire return series. I am not so concerned about positive or good returns that are volatile, in fact, I may welcome volatile returns that are above a certain point, say the risk-free-rate. However, it’s the volatility of the bad returns, or returns below a given break point that I focus on. These bad returns signal your investment is lossing money, which to us is the risk of investing. After a year of very strong equity returns, I want to make sure I preserve those hard-earned returns by limiting my downside risk.

You can find more information and insights about all of the other investment analytics that can be found in the award winning investment management platform Zephyr within Zephyr's StatFacts.

As Zephyr’s Market Strategist, Ryan Nauman provides analysis and research on market trends across asset classes, sectors, and regions to help empower better asset allocation strategy decisions. He is an accomplished investment strategist who has spent the last 22 years in the investment management industry ranging from working with plan sponsors, managing the investments of retail investors, and providing actionable thought leadership to investment professionals.

Nauman is the host of the popular Adjusted for Risk podcast. He is a well-respected investment industry strategist regularly featured on TD Ameritrade Network, Yahoo! Finance, Bloomberg TV, Bloomberg Radio and Chuck Jaffe’s Money Life podcast. His opinions and market expertise have been published in Reuters, CNBC, Bloomberg, MarketWatch.com, Yahoo! Finance, and the Wall Street Journal.