Way of the turtle

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Way of the Turtle

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measuring mutual fund performance, the Sharpe ratio does a very
good job of representing that risk because it correctly notes that for
comparisons over the same period, the confidence risk relates
directly to the variance in the returns. All else being equal, a mutual
fund with lower variance has less risk of having a return that devi-
ates from the mean return it exhibited in the past. 
Although the Sharpe ratio is an excellent measure of risk/reward
in comparing stock portfolio management strategies, it is not a suf-
ficient measure for comparing alternative investment funds such
as futures and commodities hedge funds. The Sharpe ratio falls
short here because alternative investment funds differ from unlever-
aged stock portfolios in several important areas that relate to risk: 
• Management style risk: Futures systems and funds often use
short-term trading strategies that can differ greatly from the
practices of traditional investment funds that use a buy and
hold strategy. It is possible to lose money much more quickly
with a trading strategy that involves frequent buying and selling.
• Diversification strategy risk: Many futures funds and
trading systems do not offer the same level of internal
diversification that is found in traditional investments,
having a much larger percentage of assets in a small number
of instruments at any specific time.
• Exposure: Futures have higher leverage than stocks, and
this potentially exposes futures traders to more of the risk
inherent in market fluctuations.
• Confidence risk: Many futures fund managers do not have
extensive track records. With a limited track record there is
By What Measure?
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greater risk that an investor will see returns that fall short of
expectations.
Unfortunately, the use of the Sharpe ratio tends to exacerbate
one of the problems I see in the industry, especially among those
who do not understand trading and how it differs from traditional
buy-and-hold investment in stocks: The focus on smoothness of
returns as a proxy for risk.
Let me be clear as possible here: Smoothness does not equal risk!
Very risky investments can offer smooth returns for a limited period.
Investors tend to believe that an investment or manager who has
offered consistent positive returns over a period of several years is
a safe investment. They hold this belief often without understand-
ing how those returns actually are made.
I believe that there is an inverse relationship between smoothness
of returns and actual risk in many instances. I offer two examples to
support this statement: One concerns a strategy that worked quite
well for several years and then stopped working altogether with spec-
tacular results at Long-Term Capital Management; and the second
still is employed by many funds that have been delivering excellent
returns but have the potential for the same sort of blowup.