Equity Risk Is Increasingly Non-Existent… By The Numbers

The concept of risk for hedge fund managers is a constant concern. The internal monologue goes something like this…what’s my downside if I initiate this position…how much can I lose if I am not right?”

The real answer is that you really have no idea…despite best efforts…even with stop losses [which I abhor]. The true, measurable risk of any position is only exactly known after you liquidate the position. Plus, risk management is more capital management than single stock management.


Beer-StierLittle did he know how it would all end …

Cartoon via wallstreetsurvivor.com


How much capital are you assigning to each position in the context of the entire portfolio capital? And are your different positions correlated or not? Even if they are [not], historically, there is no guarantee that correlation [or not] will continue.


Sharpe ratio


Anyway… back to risk. Every day my prime broker blasts me with a report loaded with scores of trading metrics calculated over many time frames [mostly the last twelve months]. It is all very interesting but the only real metrics I care to focus on are total returns and risk adjusted returns.

Most clients could not care less about risk adjusted returns…but I sure do. And, as many are aware, the holy grail of risk metrics is the Sharpe Ratio [as calculated according to the title of this post]. The most interesting precept of the Sharpe Ratio, in my opinion, is that it treats volatility as random…both upside and downside volatility.

No way to predict it in either direction so both directions are assigned the same discounting value. Basically, according to Bill Sharpe, all volatility is a penalty against your performance. I get it.

Still, in a perfect world, what if most of the volatility experienced by a portfolio of equities was actually favorable? So rare…if not impossible…but still at least worthy of consideration. And so the Sortino Ratio [or as I refer to it as the Gain/Pain Ratio] was born…essentially, it is exactly as the Sharpe Ratio but stratifies favored and un-favored volatility. Favorable volatility is not penalized. Unfavorable volatility is scored as a legitimate demerit. It has always seemed fairer to me.


Risk-1The difference between the Sharpe and Sortino ratios


Naturally, both ratios are relevant and higher values for both measurements reflect better risk-adjusted returns. And portfolio managers realize that, no matter the ratio, both need to positive…or you are losing money. However, given full investment of capital, the Sharpe Ratio can be strongly positive yet still not offer high absolute returns. Conversely, if your Sortino Ratio is high, you are probably delivering very strong absolute returns…again, assuming full investment of capital.


An Era of Painless Gains

Given all of this…What is a good numerical value for both ratios? Generally, over time, any value > 1.5 is pretty good and numbers > 2.0 are stellar. Be advised the data may vacillate, a little bit, based on the time frame used in your calculation i.e. weekly or monthly.

Recently I constructed a model that required one, three and five year Sharpe Ratios for the S&P 500. I also decided to include the Sortino Ratio. Prior to the results I hypothesized that the numbers ought to be pretty impressive given the endless equity “bull” since March 2009 but I was still curious to get the exact data. Plus, a weekly price chart of the S&P 500, since 2009, visually reflects the anomaly of very limited draw-downs in the context of extremely strong returns. The calculations are as follows and as Mrs. Doubtfire once said…“Effie… Brace Yourself”.


Sharpe Ratio

  • 1 Year = 1.37
  • 3 Year = 1.86
  • 5 Year =1.0

Sortino Ratio

  • 1 Year = 2.65
  • 3 Year = 3.41
  • 5 Year = 1.69


Collectively, these numbers are clearly impressive but even more so in that they are calculated from a passive, long only strategy. This is a hedge fund manager’s worst nightmare as, for five years, most “hedging” has proved to be only performance degrading.


SPX, weeklyS&P 500 index – since the 2009 low, hedging has essentially just been a performance drag, with the possible exception of the 2011 correction – click to enlarge.


Furthermore, the Sortino Ratio data are nothing short of staggering. What they really say = Plenty of Gain with Very Little Pain.…and it really is unsustainable if only because it has become much too easy to generate positive returns with very little effort, pain or savvy.


To the Ignorant the Spoils

It actually seems, at times, as though there is this mysteriously large buyer that suddenly appears whenever the equity market most “needs it”…and the subsequent buying is so aggressive and so desperate…not the style of the mostly steady “hands” I personally know. It just seems too good to be true and the Sortino Ratio numerically reflects that belief. Plus, we all know that the economic fundamentals are not as smooth as the weekly or monthly charts of the S&P 500 would suggest.

Remember that equities typically offer the most risk of any asset class…not the lowest risk as the above data set suggests. Nevertheless, Yellen and Bernanke must be “psyched” as their “wealth effect” model has been so effective…actually too effective as the market distortions grow ever larger…and more market bears become contorted “road-kill”.

To be sure these distorting effects may be entirely assigned to The Fed…the debt monetizing, interest rate suppressing “Masters of the Universe” who always get what they want while answering to nobody.

They’ve literally trounced and expectorated on the concept of “moral hazard” and, it seems, purposely reconfigured and redefined its meaning into: We have no economic morals and this poses an enormous hazard to the performance of hedged money managers. The spoils go to the ignorant only – the Fed’s true heroes.


ariel-molvig-man-standing-beside-dead-bear-yells-taxidermist-new-yorker-cartoonCartoon by Ariel Molvig


Charts by: Advisor Central, BigCharts


This article appeared as “What Risk” at GlobalSlant.


Dominique Dassault’s Twitter handle: @Global_Slant




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3 Responses to “Risk? What Risk?”

  • wrldtrst:

    Anytime a market moves slowly in one direction you will have this anomaly. No big deal really.

  • SavvyGuy:

    Markets are supposed to be unfettered mechanisms of price discovery, whether of beans, metals, crude oil, or yes…even stocks and bonds.

    There is really no way to accurately gauge risk in any market, and yet we see a lot of convenient regression analysis over various historical time periods. The problem with this approach is that it attempts to extrapolate the trend of the past, and this is the precise sort of inbred thought process that causes most portfolio managers to end up on the same side of the boat…thus providing the fuel for the market to flip the other way.

    • Crysangle:

      If every investor in 2010 knew what the SPX would look like for the next five years , it would not look like it does now.

      If every investor nowadays had a chart of the next five years … well I guess it would work out just as stated … but what would it look like ?


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