FAQ: Measuring performance

Many traders attempt to beat the index by chasing stocks that are “outperforming” the index, but they forget that high returns now will probably mean large losses later.

It is important to consider the other side of the coin: risk. That’s why we rank stocks based on the concept of mileage. Instead of miles per gallon, our metric is reward per unit risk.

If one thing riles Macnguyen most, it’s probably the lack of respect he gets for making money with such low risk. Everyone harps on one number: return. Macnguyen believes sophisticated investors, at least, should be talking about risk-adjusted return, which can be measured by a manager’s efficiency ratio. That’s annual return divided by annual volatility. The higher the ratio, the better. Ivory Optimal’s was 1.65 as of December. That beat another hard-driving hedge funder: Bill Ackman, the top manager in Bloomberg Markets’ 2014 ranking of large funds. His Pershing Square International had a ratio of 1.31.

“People don’t pay attention to guys who make money on a risk-adjusted basis when the market is up,” Macnguyen says. “In the next five years, the market isn’t going to be up as much as it has been.” — Curtis Macnguyen

The Basic Idea

Leah Modigliani explains.

Much has been said about “performance” — but almost everyone thinks of it as percent return over a certain period of time. Drawdowns are not counted.

Unfortunately, downside is all that matters because a SINGLE -30% year probably means your longer term investment objective will not be met. Why? Because the key to building wealth is compounding returns at a steady rate; therefore, the “best” performance MUST also be the most consistent — something that goes up the most with the least downward price action.

Return per unit risk

By evaluating performance that includes risk, we not only level the playing field, we make it possible to compare anything side by side.

Return per unit risk is not a new concept. The Sharpe Ratio is one measure. Modigliani M-squared is even better. Both incorporate the price return and the volatility of price return into their calculations.

Modigliani.1997-risk-adjusted-performance.pdf

Volatility of price returns is the operating definition of risk. The standard deviation of the close-to-close gain/loss over a certain period of time is usually used. Since this metric underestimates the true volatility, we should call this highway miles since only the largest bumps on the road will be captured. We’ve taken it one step further by using a second (proprietary) definition (that is closer to range) which more closely captures true volatility, and call this city miles since it actually measures the bumps.

Both are calculated and then ranked. We then add together the city and highway miles ranking to produce a combination rank. Best of all, we can put ANYTHING on the same list and rank them all to produce a definitive answer.

By definition, stocks ranked above the broad indexes ARE outperforming the index. Therefore, owning stocks that are ranked above the indexes means you will AUTOMATICALLY outperform the indexes on a risk-adjusted basis.

What if risk-adjusted performance is not enough? What if you really want to supercharge the returns by taking more risk? We could come up with one more statistic for the brave — the relative volatility of any stock on the list against these two indexes so that someone who really wants to kill themselves can use margin to leverage up the gains (and also losses).

Further Reading

Find out how the clients of Scion Capital demanded the manager to pick stocks and ruined the fund. But of course, didn’t the industry train clients to believe that stock picking and forecasting are the road to riches in the first place? With that in mind, here’s one from State Street:

SS.folklore-of-finance.pdf