But wait, how will you characterize the performance of the fund manager? Is the find manager adding any value? This question is ready for your answer. We can see that the return distribution should have the following desirable attributes, high expected returns. Low and positive skills. [MUSIC] However, these could be the intrinsic characteristic of the asset class itself. An asset class returns, as we know, a beta, and we need to distinguish, we need to isolate beta from alpha. A manager's performance is difficult to evaluate in isolation. It must be compared to the distribution of the asset class he operates on. One way to do that, to ascertain whether a fund manager can take the natural characteristics of the asset class and improve upon them. This graph demonstrates what that would look like. You have the natural asset cross and then you have the distributions provided by the manager. Expect the returns to have gone up and risk has gone down. That is an attractive characteristics. What are the typical ways in which people measure performance? In the next section we'll talk about simple measures. The distribution on the left, is clustered around the mean, while that on the right, is spread out. The variability for the mean is higher for the distribution on the right. The width of these distributions is measured by standard deviation, which is used as a proxy for risk. If a distribution is quite wide, then there is a high probability of getting a return, which is substantially away from the expected value. Since you invest precisely to get the expected value, the risk is in fact the probability that you get something far away from the expectation. Sharpe ratio is the most used and abused measure of fund performance. It is a ratio of expected excess return to excess volatility. It is a measure of reward to volatility trait. A good fund will have a high Sharpe ratio. One can use this ratio to compare similar markets, similar time periods, and similar instruments. But doesn't work across regions or across strategies for asset classes. If you combine two uncorrelated investments with high Sharpe ratios, it is a sure shot way to increase your Sharpe ratio for the portfolio. Now when a Sharpe ratio not work? One area where it doesn't give you the full picture is in hedge funds. The reason for that is that the sharpe ratio assumes a normal distribution of returns and a symmetric risk profile. It tends to ignore the fatter tails and the probabilities of extreme events. One other important point that needs to be made is that the formula does not take into account liquidity concerns. Now that we have touched upon why the Sharpe ratio may not be an appropriate tool to judge all returns, let us go a little deeper into the risk characteristics of hedge funds. Hedge funds have more leeway than traditional mutual funds. You can change strategies, as in when there's a lucrative opportunity. Plus it is difficult to be precise about the exposure of a hedge fund. Furthermore, some hedge funds invest in liquid instruments. So liquidity premiums need to be deducted through alpha to judge the performance of a hedge fund. Otherwise, what would seem to be an alpha could well be a beta for a liquidity premium. Another commonly used measure Is the information ratio. It is a variant of a Sharpe ratio that is used for benchmark relative strategies. It is a ratio of two differences, the strategy return, minus the benchmark return. Scaled by the volatility of the difference. The numerator of the portfolio is theoretically alpha and the higher the information ratio, the better the fund. There are other measures that try to overcome some of the flaws of the Sharpe ratio. In turn, they bring their own problems, one measure is Treynor's measure. Very similar to the Sharpe ratio except it uses the definition of beta in the denominator instead of volatility. So Treynor's ratio is the excess return divided by beta, where beta is the correlation divided by the ratio of the fund's standard deviation to the market. So Treynor's ratio essentially tells us the investors not only concerned about volatility, but about the correlation to the market. Yet another commonly used measure is the Sortino ration. The Sortino ratio attempts to take into account the fact that risk is asymmetric. Investors care only about downside risk or draw downs. I do not care about risk on the upside that translates into high positive returns. So the Sortino measure measures the standard deviation of drawdowns, negative returns from the mean. In other measures, it looks very similar to the sharper issue. It's the excess return minus or the instrument minus the risk free rate divided by the standard deviation on the down side. There are many more such ratios. I'll just mention some of them so you have them in the back of your mind. Jensen's alpha, Calmar ratio, Sterling ratio, Burke's ratio, and so forth. None of them provide a single magic answer to the question of performance evaluation. They all offer some insight and are good starting points. Ratios are one of the many tools that should be in investors' toolbox. They are backward looking and based solely on numbers. What is actually required is to translate this into a formal looking assessment of risk. And that needs to be complimented by a deep understand of the fund manager's strategy and the underlying economic risks.
