For those of you who remember the famous “Where’s the Beef” commercials of the 80s, a slightly different version seems to apply to plenty of the managed futures industry lately – Where’s the Return?
Our most recent newsletter is up, and we’re looking at just how the focus on low risk and risk adjusted performance is hurting the hunt for returns.
You see, there are two parts to a risk adjusted performance ratio such as the Sharpe ratio – the return, and the risk (defined as the volatility of the returns in the Sharpe ratio). Basic junior high math tells us that if we want to increase the left side of the equation (in this case the Sharpe), we can do it one of two ways: 1. Increase the returns (the numerator) or 2. Decrease the volatility (the denominator).
The result can be a very good looking program in terms of Sharpe ratio, but a ho-hum program in terms of actual return. Take the following as an example. Which of these programs would you prefer? The first one is twice as good as the 2nd in terms of risk adjusted returns, but if I am willing to accept 15% volatility, the 1st choice suddenly becomes 3 times worse.
5% ROR, 2.5% volatility = Sharpe of 2.00
15% ROR, 15% volatility = Sharpe 1.00
The question we’re tackling: what is the point of diminishing returns (pun intended) for increased risk adjusted performance? In short – if I have a great Sharpe ratio, but no meaningful return… what’s the point?
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