Sharpe Ratios of Managers

The Sharpe Ratio is a measure of the risk-adjusted return of an investment. While there are a lot of ways to measure risk, the Sharpe Ratio uses the volatility as measured by the standard deviation of returns. Originally developed by Stanford Professor William Sharpe, it is simply the return of an investment (R) minus cash sitting in T-bills (otherwise knows and the risk free rate, Rf), divided by the volatility of the investment (σ). Cash will have a Sharpe Ratio of zero.

S= (R – Rf) / σ

A good rule of thumb for Sharpe ratios is that asset classes, over the long term, have Sharpe’s around .2 to .3. A “dummy” 60/40 allocation to stocks/bonds is around .4. A good all-weather allocation is around .6. However, over shorter periods the numbers can bounce all over the place. From 1900-2007, the S&P 500 has had Sharpe Ratios per decade ranging from -.08 (the 1970s) to 1.4 (the 1950s). If you want more info on the Sharpe Ratio, Bob Fulks has a great piece here.

One of the problems with the Sharpe Ratio is that it “penalizes” upside volatility. An investor likes volatility to the upside, but dislikes volatility to the downside.

Here is a good PowerPoint that shows some historical Sharpe Ratios for some very successful managers. (It is excerpted from the book Scenarios for Risk Management and Global Investment Strategies ). Ziemba’s point is that managers should not be penalized for upside volatility, only for their losses. So even though Berkshire did almost 25% a year over this time period, it has a lower Sharpe than the S&P500 that returned only 18%. (Great Ziemba PDF here.)

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The Symmetric Downside-Risk Sharpe Ratio (Digest Summary)
William T. Ziemba
Journal of Portfolio Management, Vol. 32, No. 1: 108-122

Vanguard Windsor Fund – Managed by John Neff for 30 years, this fund was regularly in the top 5% of all mutual funds.
Berkshire Hathaway – Warren Buffett’s conglomerate holding company has returned over 20% for the past forty years.
Quantum Fund – George Soros co-managed this fund with Jim Rogers, and it returned over 40% a year in the 1970s. From 1969 to 2001 he did over 30% per year.
Tiger Management – Managed by Julian Robertson.
The Ford Foundation – One of the top performing foundations.

The first observation is how outstanding the returns were for stocks in this period, which inflates the Sharpe Ratio for the S&P 500 to one of the highest levels it has seen in the past century. The second observation is that many of these successful managers are getting penalized for making money with their upside volatility.

To gain a full understanding of a manager’s performance investors should use alternative metrics to evaluate managers. Some alternate metrics include:

Sortino Ratio: uses the volatility of negative asset returns in the denominator (similar to Ziemba’s downside symmetric Sharpe Ratio)
Sterling Ratio: uses the average max drawdown in the denominator
MAR (or Calmar) Ratio: uses max drawdown in the denominator
Ulcer index: Measures the length and severity of drawdowns.

The average return and volatility can tell you a lot, but if you really want to get nerdy check out the third and fourth momements of the return distribution, skew and kurtosis. Check out the white paper “Skewing Your Diversification” by Mark Shore.

Non-linear strategies like option selling can artificially inflate the Sharpe Ratio as they have incredibly consistent good performance until they don’t (which is usually a huge or total blowup ala LTCM).

Below is a chart from fund manager Bob Fulks who shows how an asset can have varying Sharpe Ratios depending on the time period.

LinkFest

Princeton-Newport is one of the best performing hedge funds of all time, and for a good review check out the great book Fortune’s Formula(more in the next post). 15% per year for 20 years and 3 down months is a pretty enviable track record.

Thorp has a chapter in The Best of Wilmott, and you can actually download the PDF for free here: “Models for Beating the Market“.

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A couple of housing ETFs are coming to the market:

UMM – MacroShares Major Metro Housing Up
DMM – MacroShares Major Metro Housing Down

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Dexion is launching more funds in Europe. None yet in the US.

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A new managed futures ETN hits the market (LSC). As I predicted in an earlier article in mid-07, this ETN cuts the fees in half from the Rydex fund (RYMFX) down to 0.75%. Direxion is also launching a mutual fund on the sister version of the DTI, the CTI (which exclusively invests in commodity futures).

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Nice blog with a good recent post on Tobin’s Q – Disciplined Investing

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Bill Gates at Davos

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Good post from AllAboutAlpha: Hedge funds don’t use that much leverage, and (surprising to me) most managers don’t co-invest in the fund.

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A brief history of Old Lane Partners.

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I wish I knew this when I was studying Engineering and Biology.

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I just finished reading “The Omnivore’s Dilemma” which was pretty good. The book spent a lot of time on corn (which is in everything), and the cheap prices corn was trading for. Not anymore (from Futuresource) :

LinkFest

How is it that the Celtics are only trading at slightly better than even odds to win the NBA title? From Tradesports:

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Brits turning down free money.

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Samuel Israel clearly faked it and made a run for it. It reminds me of some the the great financial thrillers by Paul Erdman (The Set-Up).

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Buffett hates fees – his bet against hedge funds. I remember having to read Clock Of The Long Nowin college.

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I know some friends that could use this: Sheep flatulence inoculation developed.

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New book in the mail: Beating the Market, 3 Months at a Timeby Appel and Appel.

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A new asset class – investing in horses?

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Apparently after Charlie Munger gave his “Psychology of Human Misjudgement” talk at Harvard in 1995 he passed out copies of this book.

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In the NYTimes Monday – “The Social Sciences Top 5“. I don’t think I’ve received a star since I was in kindergarten.

When Markets Collide


I just read El-Erian’s new book When Markets Collide this past weekend.

Am I the only person to notice that his allocation only adds up to 98%? Weird. (I just added 2% to cash.) I did like this quote from the book which reminded me of my post a couple months ago on optimizing happiness:

“There is growing talk about the importance of reducing noise lest it adversely impact quality-of-life indicators.”

Anyway, below are the allocations of the Harvard and Yale Endowments vs. El-Erian’s recommended allocation. As you can see, it is a fairly similar allocation to the Harvard endowment, with a little more in foreign bonds and no allocation to hedge funds. I lumped infrastructure in with real estate so that it could be compared to the endowments on an apples-to-apples basis.

Following that is a comparison if you back out the private equity and hedge fund allocations. Special situations was lumped into cash. He described them as:

“investment opportunities that are attractive but do not fit comfortably into the categories I have covered so far…they usually relate to two types of activities: new longer-term activities that are supported by a secular hypothesis but are yet to gain broad-based acceptance; and shorter-term activities that materialize due to sharp dislocations that involve significant overshoots.”

This seems to be somewhat of a subjective recomendation and not all that useful for the retail investor. He mentioned water, agriculture, and carbon credits as three areas for the longer-term secular activities.

The expected return is right in line with the endowment allocation I mentioned in my paper, or roughly a 1:1 return to volatility ratio (about 10% return with 10% volatility and 20% drawdown over time).

Asset Allocation vs. Interest Rates

I created a Google Custom Search Gadget and added it to the World Beta toolbar. It searches only the top 50 investment blogs. Let me know what you think (and if I should add some more blogs). You can also find the search site here where you can customize the gadget or add it to your Google homepage or blog.

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While oil is gushing to the moon today I re-read this great PowerPoint from Edward Qian at PanAgora – Multiple Alpha Sources and Risk Management. In the presentation they have a slide that shows asset class returns broken into Fed tightening and easing periods.

I thought it would be interesting to take the five asset classes mentioned in my paper and recreate the study with data going back further to 1973. Each month I recorded the year over year change in interest rates, and then the next month returns for the asset classes. For example, if interest rates declined from 5% to 4% then that would be considered a Fed easing bucket. While any number of interest rates could be used, I simply used T-Bills (and I know T-bills don’t equal fed funds but it should be close being at the short end). Below is the chart for all months from 1973-2007. In periods of fed easing, stocks, foreign stocks, bonds and REITs all performed better which makes intuitive sense because they are all capital assets and benefit from lower interest rates. Commodities on the other hand, turn in twice the returns when interest rates are going up, which makes sense due to their correlation with inflation and unexpected inflation. A simple model would be to alter portfolio weightings based on trend in interest rates. Capital assets (stocks, bonds, REITs) should have a higher percent allocation when interest rates are going down, and ditto for commodities when interest rates are going up. If I get around to it I’ll report some portfolio performance numbers for this strategy.

The red dots are Fed Tightening periods, and the blue dots are Fed Easing periods. Click on the chart to zoom in.

LinkFest

Just added The Capital Spectator to the Blogroll. Picerno has a great article on the global capital markets portfolio – and so far no ETF shop has gotten it right (they usually exclude commodities and REITs). My estimates for the global market portfolio are (comment if you have links or better numbers):

(I consider the real estate portion to be investable, it would certainly be bigger including non-investable):

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Picking up genes from your environment? Sounds like Bioshock (which is now going to be a movie).

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This sure is a bizarre story: Broadcom co-founder indicted on drug, securities charges.

In 2001, Nicholas smoked so much marijuana during a flight on a private jet between Orange County and Las Vegas that the pilot had to put on an oxygen mask, the indictment states.

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Books recommended by Warren Buffett

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The oil fields of North Dakota

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Seth Klarman now owns 25% of Horizon Lines (HRZ) and Tiger another 8%.

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Cool graphic from Ben Fry on salary vs. performance in MLB. Almost looks like an inverse correlation this year. It looks like historically that higher salaries = more wins, and here is a great scatterplot from 1997-2005. (The graphic is from Matt Sly, creator of the FutureMe website.)

Stock Screening

So far it doesn’t look like there have been any studies that divide factor research into bull/bear or trend periods. If there are any readers that use Factset (especially in SoCal)and would like to collaborate, let me know.

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I posted back in November a simple stock screen and the top picks it returned. Since that time they have returned 8% vs. -2.5% for the S&P. I’m not really a “post stock picks” type of guy (this blog is more about process and theory), but thought it was an interesting follow up. The best performer was Frontline (FRO) up 60%+ and the worst was Holly Corp (HOC) down about -25%.

What is it spitting out now? A pretty diverse group of shipping, electronics, fertilizers, REIT, housewares, engineering equipment, and egg producers.

Annaly Capital Management (NLY)
National Presto Industries (NPK)
Transocean (RIG)
Ampco-Pittsburgh (AP)
Cal-Maine Foods(CALM)
CF Industries Holdings(CF)
Frontline (FRO)
Western Digital (WDC)
Koninklijke Philips Electronics (PGH)
MOSAIC COMPANY (MOS)

LinkFest

Investing in farm stocks all over the world.

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A very cool Magnetic Movie.

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For Ray Kurzweil, the Future is Now. Did you know he runs a hedge fund?

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The dreaded Black Swan formation just showed up on the S&P. I’m not going to even comment on Taleb’s new diet.

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Bill Miller is now underperforming the S&P over a 10-year period.

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I am still waiting for someone to take me out to Urasawa. I promise I’ll pick up the next tab, and according to research we’ll both be better off.

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Credit, Housing, Commodities and the Economy from the Federal Reserve Bank of SF.

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Back in November I mentioned ProElite as a potential short, and Barron’s had an article on the shady company this weekend. It is down about 50% from then (and 75% from the highs), and I imagine on the way to 0.

Periodic Table of Returns

Here is a nice table from Prudential that shows the benefits of a good asset allocation. The second page has a statistic that shows the performance of the same allocation I use in my paper (20% each in US Stocks, Foreign Stocks, Bonds, REITs, and Commodities). 83% of the years since 1973 are above inflation, and 89% of the years are positive. They also have the data in a brochure – “The Case for Multi-Asset Class Investing“.

Weekend Linkfest

You know you’ve made it as a blogger when someone gets to your site by searching “how to blow something up” (currently 5th ranked search query on Google for that phrase). The only weirder search was “Bill Gross’s moustache”.

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Heebner is on fire.

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Who knew something as cool as the Hybrid Tech 220+ MPG Supercar would come from Mooresville, NC?

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Nice post on how consumer confidence influences future S&P returns.

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I hear the new Indy movie is awful, what a shame. How about “The original Indiana Jones: Otto Rahn and the temple of doom“?

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The Miracle Fruit That Tricks the Tongue (another article here). You can buy them here.

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The Robin Hood Charity brings in over $50 million for 2008. (The charity was founded by futures trader Paul Tudor Jones.)

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Thoughts on extinctions. I heart Olivia Judson.

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2008 Investment company factbook. There are now twice as many mutual funds as stocks in the US.

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Dean Kamen (inventor of the Segway) shows off his robotic arm:

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