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An appraisal ratio is a method of assessing an investment fund manager's performance. It does not simply measure how high a return he has achieved, but puts this into the context of how risky the investments have been. This means a high appraisal ratio is often taken as a sign of skill rather than luck.
The need for an appraisal ratio is due to the limitations of simply looking at the raw figures of a fund manager's investments. Somebody who achieves a very high return may have simply taken a risk and been lucky and the same fund manager may just as likely crash and burn in the future. While past performance is no guarantee of future results, savvy investors will want to get a better idea of how skillful a fund manager has been in the past. The way the appraisal ratio aims to tackle this problem is to take account of how volatile the relevant markets have been and thus how much potential there was for a fund manager to make a profit simply by making lucky guesses.
To calculate the appraisal ratio, the fund's alpha is divided by the unsystematic risk of the funds in which they invested. Calculating the alpha is a complicated process. Its technical definition is the intercept of the security characteristic line, that line being a graph comparison of an asset's risk to the relevant market's risk. It is easier to understand the alpha by looking at what it actually represents.
The alpha takes into account how much fluctuation there has been in a particular asset's price and how this compares to fluctuation in the underlying market. The idea is that an asset that has fluctuated more widely in value is more risky and thus more susceptible to luck rather than skill. The alpha itself is a figure showing the return on the asset after adjusting for this comparative risk.
The unsystematic risk, otherwise known as non-systematic risk, measures how much fluctuation there has been in the assets chosen by a fund manager, in comparison to the fluctuation of the entire market. The unsystematic risk thus covers issues that relate to those specific stocks, rather than overall market movements. The theory is that unsystematic risk can be lessened by diversification, or investing in a wider range of companies.
Creating the appraisal ratio using these two measures therefore serves two purposes. First, it aims to discover how much of a fund manager's success was down to skill rather than luck. Second, it adds in the fact that with sufficient diversification, luck becomes less important and the fund manager's inherent skill becomes more prominent.
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