Tuesday, November 30, 2010

You are there! The risk measure designers' annual dinner ...

Imagine for a moment that the designers of the various investment risk measures have gathered for a dinner; perhaps this is an annual event (may as well have it annual, since we like to annualize risk measures, right?). And imagine that you have the opportunity to witness what occurs; perhaps someone videotaped it and placed it on YouTube for all of us to view. We find Bill Sharpe (Sharpe ratio), Leah & Franco Modigliani (M-squared), Jack Treynor (Treynor ratio), Brian Rom (Sortino Ratio), Michael Jensen (Jensen's alpha), Fischer Black (who, along with Jack Treynor, came up with the Information Ratio), and others.

During the pre-dinner cocktail hour a debate ensues, as one after the other guests begins to argue that their formula is the most appropriate to measure and evaluate investment risk. Suddenly, Sir Francis Galton, at 188 years of age, slowly rises from a chair and boldly proclaims that it's quite evident that his is the far superior measure, and he can prove it! After all, his and his alone has been "endorsed" by GIPS(R) (Global Investment Performance Standards). And what, pray tell, is his measure? Well, if the name Francis Galton is unfamiliar to you, his measure surely isn't: standard deviation.

With the 2010 version of the standards all compliant firms must include the three-year annualized standard deviation; what further proof is needed to elevate his metric above the rest. And even if a compliant firm argues that this measure is inadequate for their strategy, they must still show it, along with an explanation as to why it isn't effective and the measure they feel is.

Well, I remain unconvinced, and will (hopefully) soon pen an article that will address this measure's weaknesses at great length (sorry, Frank!).

p.s.,With all due respect to Sir Francis, even the GIPS EC would, I believe, gladly explain that its adoption of standard deviation falls well short of an endorsement for it being numero uno when it comes to risk measures. A recommendation to include a risk measure has been part of the standards since its introduction, and the EC took it upon itself to identify a measure to be used across the board. They, no doubt, recognize many of its shortcomings but also recognize that its an easy measure to calculate and is, in reality, used by most asset managers (as shown in surveys that our firm has conducted). And so, please accept this blog's boldness (and Sir Francis' claims) as a bit of hyperbole.

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