Risk-Adjusted Returns: Sharpe, Sortino and Treynor Ratios.

Example of TenCent (.HK0700)

Introduction: The Importance of Risk-Adjusted Returns

Investors and analysts frequently assess investment performance based on absolute returns. However, raw returns alone do not provide a complete picture of an asset’s attractiveness, as they fail to account for the level of risk taken to achieve those returns. Two assets with the same return can have vastly different risk profiles—one may experience high volatility, while the other provides steady gains. To make meaningful investment comparisons, risk-adjusted return metrics such as the Sharpe Ratio, Sortino Ratio, and Treynor Ratio help investors evaluate whether an investment is truly delivering excess returns relative to its risk exposure.

Each of these ratios offers unique insights:

• The Sharpe Ratio evaluates total risk (both upside and downside volatility).

• The Sortino Ratio focuses only on downside risk, recognizing that investors generally welcome volatility when prices rise but not when they fall.

• The Treynor Ratio examines systematic risk, helping investors assess compensation for exposure to broader market movements.

By using these measures, investors can determine whether a stock or ETF is providing sufficient returns relative to the risk undertaken. In this article, we apply these ratios to Tencent Holdings (.HK0700). The  iShares Hang Seng Tech Index ETF (.HSTECH) to is used to calculate the Beta that is required for the R=Treynor Ratio.  In the weeks that follow, we will analyse other important constituents of the HSTech Index such as SMIC and AliBaba.

1. Sharpe Ratio: Total Risk-Adjusted Return

The Sharpe Ratio measures how much excess return an investment generates per unit of total risk (volatility). It is widely used across asset classes and is particularly useful for comparing investments with different risk profiles. A higher Sharpe Ratio indicates better risk-adjusted performance. Values above 1 are generally considered good, while values above 2 or 3 suggest excellent returns relative to risk.

Formula:

2. Sortino Ratio: Downside Risk-Adjusted Return

The Sortino Ratio is a modification of the Sharpe Ratio that focuses only on downside volatility. Many investors argue that traditional volatility measures unfairly penalize assets with high upside volatility. The Sortino Ratio corrects for this by considering only negative deviations from the mean return.

A higher Sortino Ratio suggests that an investment generates strong returns while minimizing downside risk. Like the Sharpe Ratio, values above 1 are good, and values above 2 or 3 are excellent.

Formula

3. Treynor Ratio: Market Risk-Adjusted Return

The Treynor Ratio evaluates returns relative to systematic risk (market risk) rather than total risk. It is particularly useful for comparing assets within a portfolio exposed to different levels of market risk (Beta).A higher Treynor Ratio indicates that an asset generates higher excess returns per unit of market risk. Unlike the Sharpe and Sortino Ratios, the Treynor Ratio is best interpreted relative to a market benchmark.

Common Benchmark Values for Sharpe, Sortino, and Treynor Ratios

Analysts use general guidelines to assess whether risk-adjusted return ratios indicate good or bad performance. While the ideal values depend on market conditions, asset classes, and investor risk preferences, here are the commonly used benchmarks:

1. Sharpe Ratio (Total Risk-Adjusted Return)

• < 0: Poor (indicating underperformance relative to risk-free assets)

• 0 – 1: Low (not attractive; return is not sufficiently compensating for risk)

• 1 – 2: Good (acceptable risk-adjusted return)

• 2 – 3: Very Good (strong risk-adjusted return)

• > 3: Excellent (outstanding risk-adjusted performance)

✅ Tencent’s Sharpe Ratio (1.45) falls into the "Good" category.

2. Sortino Ratio (Downside Risk-Adjusted Return)

• < 0: Poor (high downside risk, insufficient return)

• 0 – 1: Low (not ideal; suggests high downside volatility)

• 1 – 2: Good (acceptable downside risk-adjusted return)

• 2 – 3: Very Good (high return relative to downside risk)

• > 3: Excellent (exceptional return with minimal downside risk)

✅ Tencent’s Sortino Ratio (2.49) falls into the "Very Good" category.(Suggesting Tencent performs well with limited downside volatility.)

3. Treynor Ratio (Systematic Risk-Adjusted Return)

• Unlike Sharpe and Sortino, there is no fixed “good” or “bad” scale. Instead, the ratio is compared to market benchmarks:

  • If Treynor Ratio > Market Treynor Ratio, the asset offers better compensation for systematic risk.

  • If Treynor Ratio < Market Treynor Ratio, the asset underperforms in risk-adjusted terms.

• In practice:

  • > 0.5: Generally considered a strong Treynor Ratio for equities.

  • > 1.0: Exceptional performance compared to most stocks.

✅ Tencent’s Treynor Ratio (0.684) is considered strong, indicating good compensation for systematic risk compared to typical stocks.

Conclusion: Tencent’s Performance Based on Risk-Adjusted Metrics

• Sharpe Ratio = 1.45 → "Good"

• Sortino Ratio = 2.49 → "Very Good"

• Treynor Ratio = 0.684 → Strong Performance

Tencent exhibits a strong risk-adjusted return profile, especially when considering downside risk (Sortino Ratio). If you are risk-averse and concerned about negative fluctuations, Tencent’s performance is quite favorable.