Existing risk measures for portfolio performance are leading investment managers to misallocate capital. Corrective actions by the investment community can lead to huge payoffs because of better allocations. It is important to remember that opportunity and risk are inseparable and that the returns of hedge funds are not normally distributed, so Gaussian measures are not very helpful. The author contends that the Omega ratio is one measure that can help overcome the misallocation problem.
Many return distributions are not bell-shaped, and existing risk measures do not capture these distributions properly. The existing methods of calculating risk are leading to the misallocation of funds. According to the author, a complete rethinking of risk fundamentals can lead to huge payoffs in the productivity of investments. The Omega measure, devised by Keating and Shadwick (Finance Development Centre 2002), is a measure that can capture all of the data in any return distribution shape.
How Is This Article Useful to Practitioners?
Market participants mistakenly assume that risk can be derived from return distributions and that Gaussian tools are valid for any type of return distribution. This approach presupposes normally distributed returns, which is not the case with such leveraged investments as hedge funds. The fact that normally distributed returns cannot always be assumed highlights the need for the investment industry to fundamentally rethink prevailing risk concepts.
Existing measures encourage the separation of opportunity and risk, but the author contends that the two cannot be separated. In fact, the inseparability of opportunity and risk is acknowledged in the statement of a fund’s objectives; the goal is to gain quantitatively (annual percentage of return) and to limit loss qualitatively (preservation of capital). The tolerance for loss is unique to each investor and to each circumstance. Investors’ patience and threshold of tolerance for loss are important aspects in the investment process. The use of existing risk measures has misinformed the assessment of performance and the task of allocating investments to the best managers.
The Omega ratio is much more valuable because it captures return distributions with tail risks. It is effectively equal to the probability-weighted gains divided by the probability-weighted losses at a threshold return. The Omega ratio is equal to 1 when the threshold value is the average return. The entire return distribution can be captured in the Omega ratio. According to the author, using this measure to screen and select managers can lead to a better allocation of capital to managers. The added profitability from this effort has the potential to be huge.
The author contends that value at risk (VaR) serves a great purpose in banking, where uncorrelated risks are integrated and the resulting aggregate exhibits a normal distribution. But VaR is not appropriate for some investment portfolios, such as hedge funds. These portfolios do not exhibit bell-shaped return distributions, which can stem from a myriad of such factors as large trades, correlated positions, leverage, and illiquidity.
The author believes that the correct performance measures, such as the Omega ratio, have been developed and can be used. He thinks that the problem is behavioral because wrong concepts are deeply embedded in the investment industry and participants have not yet acknowledged the importance of not separating opportunity and risk along with using appropriate measures of risk. He states that the stakes are too high to ignore these problems indefinitely.
The current notion that risk can be treated separately from opportunity is misplaced, and corrective action by the investment community has the potential to produce huge profits from better asset allocations.