Yes, that is the problem with Sharpe ratio. That is why I think Sortino ratio is a much better version of Sharpe ratio, it takes downside volatility into account.
When Sharpe ratio is computed based on daily changes as oppose to weekly or monthly changes of the equity level, it will reflect the risk clearly. Those fund performances that return 2% a month with ok Sharpe ratio using monthly data cannot hide the real risk taken when daily data is used instead. Monthly Sharpe at around 1 to 4 will drop drastically to almost 0 if the daily equity swing is too much. Lawrence
I am not sure I agree with that fully. Take a fund trading lots of options. They may just slowly bleed premium, yet show little risk. I really think that in most cases, Sharpe just shows volatility and not directional volatility. The best way to look at a manager really is to look at a period of performance, ask yourself if there is something about his style that would make his performance much better over that time period b/c of the market. Then you talk to him and find out of he knows what he is doing. I talk with lots of guys daily. I think that within 5 minutes, I can figure out if they are any good or not, regardless of style. I am deep value, I talk with premium sellers, premium buyers, all short, short long, tech, VC, etc. These styles are mostly contrary, yet you can tell who does it well pretty fast. That is really the best way, it takes time and effort to build a portfolio of funds, but I think that it makes sense, especially if you are a fund of funds manager.
Would you care to elaborate? What type of questions/replies do you look for? Thanks I agree. Numbers do not tell the whole story.
With daily level Sharpe, the hidden "account wipe out type of equity swing" will show up - just apply it on real cases you will see We've seen this type of option model that reports Sharpe of 5+ based on monthly data and ended up reporting 0 when properly calculated based on daily data. The key is that the volatility on the equity is huge on a daily basis when the portfolio is fully leveraged. The slowly bleed premium swing wildly (e.g 0.1 goes 0.05 then back to 0.1) in terms of % change. Why then monthly data looks good? Because the options expired before the months ended One of the requirements of proper Sharpe calculation is that the resolution of the equity changes must be finer than the average position length. This important requirement is often ignored. For example, if you day trader, the better Sharpe ratio should be 5 min or even 1 min based. Use daily Sharpe can only give you an idea of the best scenerio. For average mutual funds, they use monthly data because their holding period of a security is usually longer than a month. That becomes a loophole when applying the same standard to hedge funds as they trade way more frequently and the holding period of a position is way shorter than a month. A non-option example is the Oddball system. If using monthly Sharpe, it is pretty impressive but based on daily Sharpe, it is way lower. The daily equity swing of the Oddball is so huge I think not many individuals can take such heat
Lawrence, very interesting stuff. I had never really considered that fully. Chessman- I think it is just in asking them how they apply what they are doing, what are worst case scenarios, how they respond to those? I don't know how to fully explain it. You can tell very fast though. Think of a Buffett annual letter. Read one of those and you can tell why he is one of the greatest of all time. It is a certain quality, even if you think value investing like he does is a total crock (which I certainly do not think).
Olintner wrote: "I disagree with you concerning the personal investment a) nearly 50% of ltcm assets under management was personal money of the partners (highly leveraged through loans) - it didn't help in terms of making the fund more secure." I don't see it as a guarantee, just something that improves the odds. "b) any manager who has 75% of his net worth in his own fund doesn't apply the principal of spreading risk for himself. Already 100% of his yearly income depends on the funds performance and now he is risking 75% of his own assets? For me that doesn't reassure me, it tells me he is taking high risks." It aligns the manager's interests with that of investors. It also signals that the manager believes his fund will significantly outperform a normal investment portfolio - for a good trader, the risk/reward is far better in his own funds than anywhere else. Praetorian - that's a good point about investing with guys who are still "hungry". I also agree about "sounding out" a trader. Once you have spoken to a few, you can very quickly tell who really knows their stuff and is constantly thinking about the markets, and who is just along for the ride. As a good example, think of Tony Saliba in Market Wizards - he used to take his trading sheets with him out on dinner dates. A guy who is more concerned about making money than getting laid is a good bet to outperform the S&P.
Hi Cutten, you are right, but as everyone of us starts getting richer, in relative terms, most of us get more risk averse. As an investor of a fund, I don't want to see this transition reflected in the funds performance (becoming more risk averse). If the manager wants to balance his risks, he should do it somewhere else, not in his own fund. Many managers own a big portion (20 to 30%) of their own funds (through re-investment of performance fees). Many don't keep the money in the fund to prove their worthyness to clients but to invest tax-efficient (no tax until profits are taken out). Regards, Oliver