
Appraisal Ratio
An appraisal ratio is a ratio used to measure the quality of a fund manager's investment-picking ability. The ratio is calculated as follows: Appraisal Ratio \= Alpha Unsystematic Risk where: Alpha \= rate of return for a selection of stocks Unsystematic Risk \= risk of the selection of stocks \\begin{aligned} &\\text{Appraisal Ratio} = \\frac { \\text{Alpha} }{ \\text{Unsystematic Risk} } \\\\ &\\textbf{where:} \\\\ &\\text{Alpha} = \\text{rate of return for a selection of stocks} \\\\ &\\text{Unsystematic Risk} = \\text{risk of the selection of stocks} \\\\ \\end{aligned} Appraisal Ratio\=Unsystematic RiskAlphawhere:Alpha\=rate of return for a selection of stocksUnsystematic Risk\=risk of the selection of stocks The higher the ratio, the better the performance of the manager in question. The appraisal ratio, on the other hand, is concerned with measuring the risk-adjusted return in relation to a benchmark, such as the Standard & Poor's 500 Index (S&P 500), as opposed to a risk-free asset that is guaranteed to generate investors money, such as a U.S. Treasury security. Alpha is compared to the portfolio's specific risk, providing investors with a snapshot of how many units of active return the manager is producing per unit of risk. Alpha, the portion of the return that the active management is responsible for, is compared to unsystematic risk: the portion of risk associated with the investments being made rather than with the entire securities market in general.

What Is the Appraisal Ratio?
An appraisal ratio is a ratio used to measure the quality of a fund manager's investment-picking ability.
The ratio shows how many units of active return the manager is producing per unit of risk. This is achieved by comparing the fund's alpha, the amount of excess return the manager has earned over the benchmark of the fund, to the portfolio's unsystematic risk or residual standard deviation.



Understanding the Appraisal Ratio
Managers of an active investment fund are tasked with selecting a basket of investments capable of beating the returns of a relevant benchmark or the overall market. While that sounds easy in practice, few regularly succeed in achieving this goal, especially when taking the fees that they charge into consideration.
Fortunately, there are several ways for investors to analyze how good a job fund managers do. One method to determine their investment-picking ability is to use the appraisal ratio.
The appraisal ratio measures the managers' performance by comparing the return of their stock picks to the specific risk of those selections. Alpha, the portion of the return that the active management is responsible for, is compared to unsystematic risk: the portion of risk associated with the investments being made rather than with the entire securities market in general.
The ratio is calculated as follows:
Appraisal Ratio = Alpha Unsystematic Risk where: Alpha = rate of return for a selection of stocks Unsystematic Risk = risk of the selection of stocks \begin{aligned} &\text{Appraisal Ratio} = \frac { \text{Alpha} }{ \text{Unsystematic Risk} } \\ &\textbf{where:} \\ &\text{Alpha} = \text{rate of return for a selection of stocks} \\ &\text{Unsystematic Risk} = \text{risk of the selection of stocks} \\ \end{aligned} Appraisal Ratio=Unsystematic RiskAlphawhere:Alpha=rate of return for a selection of stocksUnsystematic Risk=risk of the selection of stocks
The higher the ratio, the better the performance of the manager in question. Low appraisal ratios signal that a fund is poorly run, taking on a lot of risk to generate the returns it delivers. A high reading, on the other hand, is positive, implying that the manager is outperforming their passive portfolio benchmark without making investors sweat too much by exposing them to excessive risk or volatiltiy.
Important
Alpha and unsystematic risk values for specific funds can be found on the internet, including on several broker websites.
Appraisal Ratio vs. the Sharpe Ratio
Like the appraisal ratio, the Sharpe ratio also functions as an indicator of risk-adjusted returns. There are some notable disparities, though.
The Sharpe ratio works out the difference between the portfolio return and the risk-free rate of return. The appraisal ratio, on the other hand, is concerned with measuring the risk-adjusted return in relation to a benchmark, such as the Standard & Poor's 500 Index (S&P 500), as opposed to a risk-free asset that is guaranteed to generate investors money, such as a U.S. Treasury security.
Both financial metrics can come in handy. One of the areas where the appraisal ratio perhaps has an edge is in its index comparison. Index funds are typically the benchmark used in comparing investment performance and the market return is usually higher than the risk-free return.
The appraisal ratio is also generally more useful for measuring the consistency of an investment's performance.
Limitations of the Appraisal Ratio
Ratios that measure risk-adjusted returns can be interpreted differently. Not everyone is the same and each investor will have varying risk tolerance levels, depending on factors such as age, financial situation, income, and general personality.
Another point worth raising is the complications that can arise when comparing multiple funds against a benchmark. Each fund might have different securities, asset allocations for each sector, and entry points in their investments, making such assessments difficult to interpret.
As is the case with all financial ratios, it’s generally best to consult several of them rather than relying on just one. The more information that is taken under consideration, the better chance investors have at making more comprehensive and informed decisions about where to allocate their money.
Related terms:
What Is Active Management in Investing?
Active management of a portfolio or a fund requires a professional money manager or team to regularly make buy, hold, and sell decisions. read more
Active Risk
Active risk is a type of risk that a fund or managed portfolio creates as it attempts to beat the returns of the benchmark against which it is compared. read more
Alpha
Alpha (α) , used in finance as a measure of performance, is the excess return of an investment relative to the return of a benchmark index. read more
Asset Allocation
Asset allocation is the process of deciding where to put money to work in the market. read more
Attribution Analysis
Attribution analysis is a quantitative method for analyzing a fund manager's performance based on investment style, stock selection, and market timing. read more
Benchmark
A benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured. read more
Excess Returns
Excess returns are returns achieved above and beyond the return of a proxy. Excess returns will depend on a designated investment return comparison for analysis. read more
Fund Manager
Learn more about fund managers, who oversee a portfolio of mutual or hedge funds and make final decisions about how they are invested. read more
Income
Income is money received in return for working, providing a product or service, or investing capital. A pension or a gift is also income. read more
Index Fund
An index fund is a pooled investment vehicle that passively seeks to replicate the returns of some market indexes. read more