Measuring Risk-Adjusted Returns in Alternative Investments
Academic criticism of classic Capital Asset Pricing Model (CAPM) performance measures is not new.
Principal, Premia Capital Management, LLCResearch Associate with the EDHEC Risk and Asset Management Research Centre
In particular, a number of authors have pointed out the shortcomings of using the Sharpe ratio for performance evaluation and the mean-variance framework for portfolio construction when the underlying investments have highly nonsymmetric distributions. A number of hedge fund strategies have asymmetric outcomes, either because they explicitly use derivatives or because their return profile involves taking on some implicit short options risk. Until recently it was fine to use the Sharpe ratio as a way of summarizing the attractiveness of an investment. This ratio is the investment's excess return over T-bills divided by the investment's standard deviation. The reason for the measure's acceptance is that given the persistence of superior stock market returns, the predominant investment has been portfolios of equities. And research since the 1970's has shown that diversified portfolios of equities have symmetric outcomes.
But given the stock market downdraft since March 2000, mutual fund inflows have dramatically slowed down while hedge fund investing has exploded. As a matter of fact, according to Morgan Stanley, net hedge fund inflows grew to the same size as net mutual fund inflows in 2001. Therefore, only now have the shortcomings of using traditional performance measures to evaluate all manner of strategies become relevant to investors. In this column, I'll briefly touch on the problems with using traditional performance evaluation methods, and later I'll summarize the state-of-the-art in alternative performance evaluation techniques.
Measuring Risk-Adjusted Returns in Alternative Investments...
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