Taxi in Ollantaytambo, Peru

There are several “efficiency ratios” one might use to measure portfolio return per unit of risk. The Sharpe Ratio is one of the best as it gives information how efficiently the returns were earned. The equation for the Sharpe Ratio looks like this.

Sharpe Ratio = (Portfolio Return for Period P – Risk-Free Rate of Return for Period P)/Sigma or Standard Deviation. In simpler form it is as follows.

SR = (PR – RF)/SD

Running these calculations for each ETF used to populate a portfolio is a daunting task. Fear not for behold Morningstar does this for us. Once on the Morningstar site, select your EFT and then click on Risk Measures. Here is an example for the Vanguard ETF, VB, or Small-Cap Blend.

http://quicktake.morningstar.com/etfnet/RatingsAndRisk.aspx?Country=USA&Symbol=VB

While you are in the Risk Measures section of Morningstar, check out the Alpha, Beta, R-Squared, and other statistical metrics. While I can determine the Sharpe Ratio (SR) for an individual ETF, I don’t know if Morningstar shows the SR for a portfolio. So far, I have not been able to locate that information.

Three Gorges Dam Project, China

Relative Strength Index: What is it and why is it useful?

Quoting from the StockCharts site, “the RSI compares the magnitude of a stock’s recent gains to the magnitude of its recent losses and turns that information into a number that ranges from zero to 100.” The RSI is an oscillator and the developer, J. Welles Wilder, recommends using 14 periods. When using the RSI oscillator, we will stick with the recommended 14 period.

For detailed information on the RSI and how it is calculated, go to the site referenced below.

http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:relative_strength_index_rsi

If you are like me, there are times when a second reference is useful as it frequently clarifies ideas that may be absent in the first read. Here is another RSI reference.

http://en.wikipedia.org/wiki/Relative_strength_index

To use the RSI oscillator, go to the StockCharts link on the right-hand side of the page. Type in the stock ticker or ETF ticker of interest. Under the price graph for the stock or ETF, you will see the Relative Strength Indicator (RSI). When the line moves from below to above the 30% line, it is a buy signal and when the line moves from above to below the 70% line, it is a sell. In most cases we find the line is somewhere between the 30% and 70% line. What do we do if we are in the process of populating a portfolio as is currently the situation with the AA-Mosaic Portfolio? If we have a choice between two ETFs, we will likely go with the one that has the lower expense ratio, and when possible, choose the one with the lowest RSI percentage. We will not necessarily wait for the line graph to drop below the 30% level before we make a move.

Physlab

Sunset at Twin Rocks – Photograph by John Hill

For the first time since launch, the AA-Mosaic Portfolio turned positive. As of a few minutes ago, the Internal Rate of Return (IRR) is 7.6% while the VTSMX benchmark is a negative 17.7%.  The -17.7% will change for the better if the market continues to hold the gains today.  The price of the index is not fixed until the close of the day.  The boost to the AA-Mosaic Portfolio is coming from Fastenal (FAST), emerging markets, small-cap, commodities, small-cap value, and REITs. The big loser is the mid-cap growth VOT ETF.

The gap between the portfolio and the VTSMX benchmark will close over time, but we do expect to see the portfolio maintain a lead over the benchmark.

Dubrovnik, Croatia

Another ratio used to measure portfolio return vs. risk is the Information Ratio. Check this site for one definition.

http://en.wikipedia.org/wiki/Information_ratio

The following site gives the reader a comparison between the Sharpe Ratio and the Information Ratio.

http://seekingalpha.com/article/63911-clarifying-the-information-ratio-and-sharpe-ratio

I have software that permits me to calculate the information ratio from alpha and standard deviation. Eventually, I plan to provide this information for the AA-Mosaic Portfolio. If the Information Ratio is positive, then we know the portfolio manager is adding value to the portfolio.

Photograph: Oregon Coast

While the AA-Mosaic Portfolio continues to maintain a commanding lead over its VTSMX benchmark, the percentages are not all that meaningful as they swing wildly with any volatility in the market. At the close of 2/28/2008, the IRR for the portfolio showed a slight gain of 0.9% while the VTSMX benchmark was lagging with a negative -19.4%. The VFINX or S&P 500  index is negative 19.3%. Performing a bit higher is the total international index (VGTSX) at negative 6.8%.

It is encouraging to see a diversified portfolio maintain this lead, knowing full well the gap will likely close as the different asset classes revert toward their mean value.  Nevertheless, we do expect the AA-Mosaic Portfolio to perform better than the VTSMX without taking on too much additional risk.