The risk-reward ratio can be gauged more accurately through a measure called the Sharpe ratio. It’s a reward-to-risk ratio that measures the return above risk-free rate per unit of volatility for holding the investment. The graph below plots the Sharpe ratios based on the explained calculations.
S(X) = (R – R(f)) / SD
Where R is the average return from investment X; R(f) is the best available rate of return of risk-free security; SD is the standard deviation of the return from X or measure of volatility.
The higher the Sharpe ratio, the better it is for the investors. This is because the returns are higher per unit of risk, as denoted by the formula above. In our analysis, we used the average five-year Treasury rates for the five-year comparison; for the three-year term, three-year Treasury rates for three years; and a three-month Treasury rate as risk-free rate since January 2014. Using the above formula, it was found that Sharpe ratio had been the highest for XLY for both the three-year and five-year periods. In other words, XLY outperformed rest of the ETFs on risk-adjusted basis, closely followed by DEF. While general economic condition contributed to superior performance of XLY, the contrarian nature of DEF ensures that risk-adjustment paid off during periods of relative uncertainty. Investors in bond ETFs like HYG and JNK would have received returns better than or at par with SPY for per unit of risk.
When we compare these results with very short term (viz. since January 2014), we find that Sharpe ratio has been negative for cyclical, counter-cyclical ETFs, and SPY, while it was positive for JNK and HYG. It implies that risk-free assets outperform the investment on a risk-adjusted basis. Investors often flood the bond market in search of highest risk-adjusted returns available. Negative Sharpe ratios are quite common during bear markets. It should be noted that the above conclusions are based purely on the risk-return trade-off of the ETFs. The past relative performance is not an indication of the future performance.