Ratio's

Question 1

What might happen to the sharpe ratio when you remove upside volatility in a fund with a positive skewness

Answer 1

It might increase -> counter intuitive

Question 2

A) would you say portfolio X outperformed or underperformed compared to the S&P 500
b) Briefly explain the conflict of results

Answer 2

Question 3

Answer 3

Question 4

What is the sharpe ratio and when is it appropiate to use?

Answer 4

Sharpe ratio measures return compensation per unit of total risk,
with risk measured by std. dev. -> slope of capital allocation line
Appropriate when portfolio represents entire investment for an
individual -> total volatility matters

Question 5

Can you mention three drawbacks of using a factor model for performance evaluation?

Answer 5

1) Noise in estimating style or risk loadings (betas) leads to noisy alpha estimates
2) True factor loadings may be time-varying -> ignoring this leads to biased alphas
3) Factor model can miss important risk/style factor -> also leads to incorrect alpha

Question 6

What are the pro’s and cons of Alpha?

Answer 6

Pros:
* Simple to compute (linear regression)
* Statistical significance easy to test (t-statistic of intercept)
* Level has intuitive interpretation (abnormal return)
* Direct measure of return added by manager (skill?)
Cons:
* Noise in beta estimates leads to noise in alpha estimates
* Betas may vary over time due to timing or style switching  alpha biased!
* Does not distinguish between good and bad betas
* Alpha depends on benchmarks (factors) in model
* Alpha can be simply boosted by using leverage
* Does not account for portfolio size (AUM)

Question 7

What are the pro’s and cons of the Treynor Ratio?

Answer 7

Pros:
* Distinguishes between systematic and idiosyncratic risk
* Intuitive conceptual interpretation (reward per unit of beta risk)
Cons:
* Assumes that beta is positive and constant
* Does not distinguish between good and bad beta -> most investors only care about downside beta
* Requires beta estimation -> sensitive to chosen benchmark
* Treynor ratio per se does not say much -> comparison needed

Question 8

What ratio is a problem for hedgefunds with a negative skewness

Answer 8

The sharpe ratio

Question 9

When might sharpe ratio be overstated in a (hedge) fund

Answer 9

Funds with a negative return distribution

Question 10

What is are some information ratio pro’s and cons

Answer 10

Pros:
* Accounts for idiosyncratic risk (deviation from benchmark)
* Intuitive conceptual interpretation (active return/active risk)
Cons:
* Same as for any measure that uses alpha as input
* IR per se does not say much  comparison needed
* In practice, IR of 0.5 p/a considered “good” and IR > 1.0 “exceptional”
* Only 10% of mutual fund managers have IR > 1.0

Question 11

What is the information ratio and what is the formula

Answer 11

The information ratio divides the alpha of the portfolio by nonsystematic risk,
called “tracking error” in the industry. It measures abnormal return per unit of risk that in principle could be diversified away by holding a market
index portfolio
If a stock is part of the index market fund, you can use the information ratio to measure the “contribution to the overal sharpe” . a higher information ratio adds more value to the portfolio

Question 12

How do you calculate the treynor measure

Answer 12

When employing a number of managers in a fund, the nonsystematic risk of each will be largely diversified away, so only systematic risk is relevant. The appropriate
performance metric when evaluating components of the full risky portfolio is now the Treynor measure. This reward-to-risk ratio divides expected excess return by systematic risk (i.e., by beta).

Question 13

The index regression model formula

Answer 13

Question 14

What is the sharpe ratio and when is it appropiate to use?

Answer 14

Sharpe ratio measures return compensation per unit of total risk,
with risk measured by std. dev. -> slope of capital allocation line
Appropriate when portfolio represents entire investment for an
individual -> total volatility matters

Question 15

What is the Sortino ratio and when is it appropiate to use?

Answer 15

Sortino ratio measures return compensation per unit of bad
(downside) risk, with risk measured by downside deviation
* Downside deviation is std. dev. of all returns < Rf
* Idea: upside volatility is beneficial to investors  not a risk
* Std. dev. overstates risk for positively skewed return distributions
-> Sharpe ratio may increase when removing largest + returns!
* Std. dev. understates risk for negatively skewed distributions

Question 16

What are the pro’s and cons of the Sortino Ratio?

Answer 16

Pros:
* Explicitly distinguishes between good and bad volatility
* Does not assume that returns follow normal distribution
* Allows comparison across asset classes (benchmark is Rf)
* Intuitive conceptual interpretation (reward per unit of bad risk)
Cons:
* Noisier than Sharpe ratio when return distribution is symmetric
(fewer observations used to compute downside deviation)
* Does not distinguish between systematic and idiosyncratic risk
* Sortino ratio per se does not say much  comparison needed

Question 17

What do you see here

Answer 17

Left: positive skewness; trend following hedgefunds
right: negative skewness; hedgefund that sell out of the money

same sdev, negative skew has way more downside risk

right; sdev overstated risk
left; understates true risk