Strategic Investing- Leveraging Risk Analysis Ratios for Optimal Portfolio Management

Both investors and fund managers may effectively measure and manage mutual fund risk with the use of risk analysis ratios. Investors can better manage the complexity of the financial markets and match their investment strategies with their preferred risk-return profile by exploring the nuances of these ratios in more detail.

Treynor Ratio:

• The Treynor ratio is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.
• It basically measures returns earned in excess of that which could have been earned on a risk-free investment per each unit of market risk.
• Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio.
• It is different from the Sharpe ratio in the sense that the Treynor ratio uses systematic risk to measure volatility instead of adjusting portfolio returns using the portfolio's standard deviation as done with the Sharpe ratio.

T= Treynor Ratio, rp = Return of the Portfolio , rf= Risk-Free Rate , βp = Beta of the Portfolio

• Although raw returns of a fund give a quick overview of its performance, using risk-adjusted metrics such the Treynor and Sharpe ratios gives a more thorough evaluation.
• The Treynor ratio does not particularly reward a Portfolio Manager for taking risks that could be eliminated through diversification.

VaR (Value at Risk):

• The value at risk (VaR) ratio is a risk management ratio that is used to measure the potential loss that an investment portfolio may face over a specific time period at a given confidence level.
• It is mostly used by investment and commercial banks to determine the extent and probabilities of potential losses in their institutional portfolios.
• It is expressed as a ratio of the potential loss to the value of the investment portfolio.
• For example, if a portfolio has a VaR ratio of 5%, it means that there's a 5% probability that the portfolio will incur losses greater than the specified VaR amount over the given time period.
• VaR is often criticised for offering a false sense of security, as it does not project the maximum potential loss. Therefore, the statistically most probable outcome that it offers, is not always the actual outcome.

Debt to Capital (D/C):

• The debt-to-capital ratio is an example of a leverage ratio, measuring the financial leverage of a company by comparing its total liabilities to its total capital.
• “Debt” includes all short and long-term liabilities, while the “shareholder’s equity” figure should be a sum of all company equity, from common and preferred stock to minority interest.
• A higher debt-to-capital ratio indicates a higher degree of financial leverage, meaning that the company relies more on debt financing. Conversely, a lower ratio suggests a lower level of financial risk as the company has less debt relative to its total capital.

Debt-to-Capital Ratio = Total Debt /Total Debt + Shareholder’s Equity

• Since this ratio is dependent on current financial scenarios of a company, if calculations are made according to numbers from account books in the past, then this ratio might not give an accurate estimate of the actual leveraging position of the company.

Asset by Equity:

• The Asset to Equity Ratio is the ratio of total assets divided by stockholders’ equity.
• The asset/equity ratio indicates the relationship of the total assets of the firm to the part owned by shareholders. Hence, it is a reflection of the company’s current asset holding and debt financing position.
• A higher ratio indicates more assets are financed by equity, indicating lower financial risk. However, a lower ratio may indicate higher financial risk, as more assets are financed through debt.
• The ratio is of great use to investment and fund managers who are trying to assess a company’s level of financial leverage. If the ratio turns out to be high, then it indicates that the company relies more on equity financing rather than debt financing. A lower ratio will tell the manager that the company relies heavily on debt financing, rather than utilising shareholder’s money, which is a negative sign.
• Investment managers track changes in the asset to equity ratio over time to identify trends in the company's capital structure.