M2 Measure:

 M2 measure is an extended and more useful version of the Sharpe ratio which gives us
the risk-adjusted return of the portfolio by multiplying the Sharpe ratio with the
standard deviation of any benchmark market index and adding risk-free return
thereafter to it.
 M2 measure is also known as Modigliani risk adjusted performance (RAP). M2
measure helps in knowing that with the given amount of risk taken, how much the
portfolio will reward an investor, in terms of the risk-free rate of return and benchmark
portfolio. It was developed by Nobel prize winner Franco Modigliani and his
granddaughter Leah Modigliani in the year 1997. M2 measure is calculated by
multiplying the Sharpe ratio with the standard deviation, hence, we should understand
these terms in order to get a better understanding.
 Sharpe Ratio: It’s a measure of risk-adjusted return of a financial portfolio. A portfolio
having the higher Sharpe ratio is considered to be more beneficial than others having a
comparatively lower Sharpe ratio.
 Standard Deviation: It’s a measure of the amount of deviation from the average of
specific set of values. A portfolio having a higher standard deviation would indicate a
higher level of risk since it depicts that the returns may vary a lot over a period of time.

Formula for M2 Measure

The following are the steps or formulas for the calculation of the M 2 measure.

Step 1: Calculation of Sharpe ratio (annualized)

Sharpe Ratio Formula: (SR) = (rp – rf) / σp

Where: rp = return of the portfolio; rf = risk-free rate of return; σp = standard deviation of the

excess return of the portfolio

Step 2: Multiplying Sharpe ratio as calculated in step 1 with the standard deviation of the
benchmark = SR * σ benchmark

Where, σ benchmark = standard deviation of benchmark

 Step 3: Adding the risk-free rate of return to the outcome derived in step 2

SR * σ benchmark + (rf)

M squared measure = SR * σ benchmark + (rf)

M2 measure is the excess return, which is weighted over the standard deviation of benchmark
and portfolio increasing with the risk-free rate of return.
Example: Market Portfolio: Market Risk (rm): 22, Risk free return (rf): 12, σ benchmark: 6

Investor’s Portfolio: Portfolio risk (rp): 26%, Risk free return (rf): 12%, σp: 7

1. Calculation of Sharpe ratio

Sharpe Ratio (SR) = (26 – 12) / 7
Sharpe Ratio (SR) = 14 / 7
Sharpe Ratio (SR) = 2
2. Calculation of M2 measure
M2 = SR * σ benchmark + (rf)
M2 = 12 + (12)
M2 = 24 %

Advantages

1. It is a risk-adjusted performance metric that is easy to interpret.

2. M2 measure is more useful when compared with the Sharpe ratio from which it is derived
because it is awkward to interpret Sharpe ratio when the same is negative.
3. Also, one might find it difficult to compare Sharpe ratios directly from different investments.
Like if one wants to compare two different portfolios, one having a Sharpe ratio of 0.60 and
another having −0.60, then it would be difficult to conclude that how worse the second
portfolio.
4. The same is in case of another measure like Treynor ratio, and other ratios, which are calculated
in terms of ratio. This problem is overcome in Modigliani risk-adjusted performance as it is in
percentage return unit, which can be interpreted instantly and easily by all the investors.
5. So, it is easy to know the difference between the two or more investment portfolios. Like M2
values of portfolio one is 5.4% and of the second portfolio is 5.9%, then it shows that there is
a difference of 0.5 percentage risk-adjusted return with riskiness adjusted with the benchmark
portfolio.
6. The advanced form of Sharpe ratio: Sharpe ratio is difficult to interpret when it is negative,
moreover, it is not convenient to directly compare Sharpe ratios of various investments whereas
M2 measure is a better and more useful form of Sharpe ratio.
7. Measurement of the risk-adjusted rate of return: M2 measure helps us in finding the returns
achieved by the portfolio in terms of risk assumed by it as it measures the risk-adjusted return
of the different investments.
8. Overcomes drawbacks of Sharpe, Treynor, and similar ratios: It is difficult to compare
Sharpe ratio directly from different investment. As Modigliani risk-adjusted performance is in
the percentage return unit, it can be easily interpreted by all investors.
9. Comparison with different portfolios: M2 measure facilitates the comparison of two
different portfolios.
10. Easy to interpret: It is a risk adjusted performance yardstick. Hence, it is easy to interpret and
fetch conclusions from its projections
11. Thus, it helps in comparing the two different portfolios.

Disadvantages of the M2 Measure

-Manipulation by the portfolio manager: The portfolio manager handling the affairs of M2
measure can influence the results to boost the history of risk-adjusted returns.

-It subsumes only historical risk: The data from which M2 measures are calculated
assimilates only the historical risk.

Important points of the M2 measure

1. The calculated return of the portfolio will be equal to the M2 measure when the portfolio’s
standard deviation is equal to the standard deviation of the benchmark. This generally happens
when the portfolio is tracking an index.
2. The M squared measure also has an alternative where a systematic risk component will be used
in place of the full volatility component. The same, however, will be a good indicator only if
the portfolio under consideration is a well-diversified portfolio because under diversification
may lead to underestimation of the portfolio’s riskiness as some idiosyncratic risk will be left
in that case.
3. The M2 measure is derived directly from the Sharpe ratio so, any portfolio orderings using the
M2 measure will exactly be the same as the portfolio ordering using the Sharpe ratio.
4. M2 measure helps in measuring the returns of portfolios after adjusting the risk associated, i.e.,
it measures the risk-adjusted return of the different investment portfolios relative to a
benchmark.
5. M2 measure is also sometimes known as M squared, Modigliani–Modigliani measure, RAP
(risk adjusted Portfolio, or Modigliani risk-adjusted-performance.
6. One can interpret the M2 measure as the difference between the portfolio’s scaled excess return
with that of the market, where the scaled portfolio has volatility being the same as that of the
market.
7. The M squared measure is calculated from the famous and widely used ‘Sharpe ratio’ with the
added advantage that it is in units of the percent return, which makes it more intuitive for the
interpretation by the user. M2 measure is important as it gives us the risk adjusted return of the
portfolio i.e., risk-free rate of return.
8. M2 measure can easily be interpreted by us as it is in the form of percentage return unit so it
overcomes the problem of concluding that how worse the negative portfolio is.
9. We can find out the difference between the performances of the two portfolios easily. For
example, if the value of the M2 measure for portfolio X is 1.9% and the value for portfolio Y
is 1.53% then the difference between the two portfolios is 0.37%. This shows that portfolio X
is performing better since its returns are better taking into account the risk assumed by it.

Conclusion: M2 measure is much diversified and acts as a helping tool in terms of portfolio
management. It helps to understand that with the given level of risk assumed in a portfolio how
well the portfolio is going to incentivize the investor as compared to the risk-free rate of return
and benchmark portfolio. Therefore, if an investment is taken under consideration having more
risk than benchmark, with little benefits, then it might have a lesser amount of risk adjusted
performance. M2 measure facilitates the interpretation and helps in the comparison of two or
more portfolios by the investor.

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