People don’t perceive that they are going to be the one in a crash,” laments Russ Rader, media director at the IIHS (Insurance Institute for Highway Safety). “They believe that they are in control when they’re behind the wheel. They don’t sense how high the risk actually is.” The IIHS, a Virginia-based, national nonprofit that has helped significantly increase seat belt usage in the last twenty years, has a simple objective: lessen the risk taken in everyday driving behavior. The risk-measurement approach it employs has the potential to revolutionize how the investment community evaluates manager performance.
In our industry any credible performance comparison is risk adjusted. It makes no sense to equate the returns of two funds that take different amounts of risk. The challenge has always been how to measure the risk taken by managers—mathematically speaking, what to stick in the denominator.
In our industry any credible performance comparison is risk adjusted. It makes no sense to equate the returns of two funds that take different amounts of risk. The challenge has always been how to measure the risk taken by managers—mathematically speaking, what to stick in the denominator.
Formulas generally fall into one of two categories. Those in the first category, inculcated in CFP®/CFA® study courses as the definitive way of measuring risk, view the variance of past returns as the primary indicator of risk. The Sharpe ratio, Sortino ratio, information ratio, Treynor ratio, and the Morningstar risk rating all fall into this category. Canonized by great thinkers such as Harry M. Markowitz and William Sharpe, these approaches gave us a way to measure risk with precision and a toolbox for evaluating performance. Look at returns as a distribution, MPT (modern portfolio theory) told us, and you can apply measures like skew, kurtosis, standard deviation, correlation, beta, and alpha. The second school of evaluating performance—found in the Calmar, MAR, and Sterling ratios—suggests that the risk denominator should be a manager’s maximum historical drawdown. There is something elegant and candid about this approach: it says to managers, “No amount of positive performance will make up for that downturn.” Critics have jumped on both schools for their reliance on applying past correlations to future market events. Yet there is a larger, more fatal flaw in both of these schools that has yet to be adequately addressed: neither solves the “seat belt problem.” . [..]
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