Tuesday, 04 June 2013 - 20:00

 

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A Closer look at Risk Measurements

From a fund of fund perspective it is always useful to conduct a proper analysis on a wide spectrum of managers. One way to do this is by conducting quantitative analysis, which enables you to screen and compare managers with different characteristics. The quants allow one to gain a better understanding of the fund and its strategy and can be easily interpreted. Depending on the ratio investigated, the investor either prefers a high or a low number.

One way to use quant analysis is to calculate different risk/return measures. As there are numerous measures, the question one needs to ask then is what do you define as risk?

In laymen’s terms, portfolio risk would usually refer to the volatility of returns. The statistical measure for this is called the standard deviation (also known as volatility risk). Essentially it measures the movement of returns around the average return of the fund.

Unfortunately with finance, statistics and maths aren’t always that straight forward. Apart from a list of statistical assumptions one needs to accept, one major flaw of using standard deviation as a measure of risk is that it penalises upside (good) and downside (bad) movements, even though upside movements are sought after. Although standard deviation may be misleading, it is a highly popular measurement and is used in the calculation of the Sharpe ratio.

The Sharpe ratio measures the return above the risk free rate (usually assumed to be cash) relative to standard deviation, where a higher Sharpe ratio is preferred. Below is a comparison of the Sharpe ratios between the ALSI, ALBI and ASISA Multi Asset Medium and High Equity Funds.

Based purely on the Sharpe ratio, the ASISA South African Multi Asset Medium Equity class had the best risk adjusted returns over all periods. Moderate funds have a maximum equity exposure of 60%, and for this reason their standard deviation tends to be lower since returns are not as volatile as with the ALSI. This does not mean that it would have provided the best return but rather that this asset class would have provided you with the least volatile risk adjusted return above cash.

At Seed, we try and form an objective opinion about every asset that we invest into. While historic returns aren’t a reflection of the future, when conducting quantitative analysis the past forms an observable character of a fund and this is then used as a proxy for certain characteristics which can be expected going forward.

Since the Sharpe ratio has many flaws we at Seed place more credibility on the Omega ratio. The Omega ratio is relatively new and not so well known to the investment public, but is especially useful for comparing managers when one is benchmark cognisant. This is especially useful for comparing funds that aim to track a certain benchmark.
For the Omega ratio, the benchmark will essentially form an integral part in the outcome of the ratio. As seen below, the Omega ratio can be seen by dividing the area above the benchmark by the area below the benchmark.

The Omega ratio measures the probability of outperforming a set benchmark over the probability of underperforming that same benchmark. The ratio thus defines any returns below the benchmark as a loss, which can also be seen as its interpretation of risk. Apart from its statistical superiority, it is also easy to interpret - the higher the Omega, the better.

The calculations behind the Omega ratio are a bit daunting and should you require any further information or would like to know more about the ratio and its uses, feel free to contact us and we can send you a research study we have conducted on quantitative measurements.

Warm regards,

Lourens Rabe

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 04 Jun 2013

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