New Risk Metrics for a New World by Marc Odo, CFA®, CAIA®, CIPM®, CFP® December 2017 New Risk Metrics for a New World 2 INTRODUCTION
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New Risk Metrics for a New World by Marc Odo, CFA®, CAIA®, CIPM®, CFP® December 2017 New Risk Metrics for a New World 2 INTRODUCTION Following the Financial Crisis of 2007-09, designed for alternative investments. These post- there was an explosion of investment products MPT metrics are not yet in widespread use, but designed to not track the market. Hundreds of they are gaining attention in certain circles. This hedge funds and liquid alternatives were unveiled paper focuses on several new post-MPT statistics post-crisis as investors clamored for investments that are worth using. with low correlations to markets and minimal But before we move into the new metrics to use, systematic risk. The release of all these products we should first identify what exactly we should gave birth to a new problem —performance and be measuring. So one should ask themselves, risk measurement. If alternative investments were “What are alternative investments supposed to designed to behave differently than the market, do?” I propose investors use alternatives for three does comparing them to the S&P 500 index make primary objectives: to minimize losses; to avoid, any sense? This is especially relevant since the or at least minimize, the impact of tail risk, also S&P 500 is up over 300% since the market bottom known as extreme “black swan” events; and to over eight years ago. provide consistent, steady returns through most In short, how can one tell if an alternative fund is market environments. doing its job? In connection to these objectives, I discuss the Most of the commonly used performance metrics following new measurements: were designed for traditional, active money 1. Minimizing losses: pain index, pain ratio managers. Traditional active managers typically seek to add incremental value over a benchmark 2. Avoiding tail risk events: omega, upside/ by making marginal bets on sectors or individual downside omega securities. Modern Portfolio Theory (MPT) statistics 3. Provide consistent, steady returns: Zephyr like alpha, beta, tracking error, and information K-ratio ratio are well-suited for such managers. However, Before diving into these new metrics, I preface they aren’t as useful for investments that are, the discussion by introducing a useful framework by design, going to have return patterns quite for categorizing and understanding the role different from the market. that various performance metrics play: StatMAP Fortunately, there is a new generation of metrics Framework. Swan Global Investments | 970-382-8901 | swanglobalinvestments.com New Risk Metrics for a New World 3 THE StatMAP FRAMEWORK There are dozens upon dozens of risk and return posted something in the neighborhood of 8%, it measures available and keeping them straight has low volatility, and thus low risk. Conversely, if is a challenge. In a previous role as Director of the range of returns spanned from -32% to +48% Research at Zephyr Associates, I developed this on a year-to-year basis, with little predictability as framework in order to help people understand all to where the investment would be in any given the various measures available. The vast majority year, it has high volatility, and thus high risk. of the performance measures can be classified in Volatility was the original measure of risk and one of three ways: measures of return; measures remains a valid concept. of risk; and measures of return-vs-risk trade-off (usually represented as a ratio). 2. Relative to a Benchmark Generally speaking, the higher or larger the During the 1980s and 1990s, the most popular measures of return, the better. Conversely, one performance metrics were measures like alpha, hopes the values of the various risk measures beta, information ratio, and capture ratios. What to be as small as possible. Finally, since return- these metrics have in common is they all use a vs-risk measures are typically expressed as suitable market index as a benchmark. They are ratios with return in the numerator and risk in the all calculated relative to a standard measuring denominator, one would like to see the trade-off stick. I believe this was for two reasons. ratios like Sharpe ratio and information ratio to be First, equity markets enjoyed a remarkable bull run as large as possible. between 1982 and 2000. The rising tide lifted all The other axis on which we can organize our boats. Second, it was during this era that passive thoughts is risk. There are many different ways to investing established itself as a viable approach. define risk, and focusing on one while ignoring Vanguard and then later the ETF providers others leaves blind spots in our understanding promised to match market returns very affordably of it. In order to provide a holistic view of risk, I rather than potentially outperform at a hefty price. propose four broad classifications: With the bull market and passive investing as a 1. Risk in terms of volatility backdrop, it is no wonder that benchmark-driven metrics became popular. If one was an active 2. Risk relative to a benchmark manager, one had to “prove” added value over 3. Risk in terms of capital preservation a passive option, and metrics like alpha and 4. Risk in terms of tail risk information ratio are designed to do just that. The shortcomings of benchmark-relative metrics 1. Volatility were exposed during the first decade of the new This framework reflects the evolution in thinking millennium. In the span of less than ten years, we over the last 50-60 years. When Harry Markowitz experienced the two worst bear markets since and his contemporaries developed the ground- World War II. During the dot-com bust of 2000-02, breaking Modern Portfolio Theory, risk was most markets lost almost 45%, then during the Financial often described in terms of volatility. Because Crisis of 2007-09, markets fell over 50%. In these investment returns were often described using kind of environments, it is entirely possible that a long-term averages, volatility was used as a cross- manager would have outperformed its benchmark check on the validity of those long-term averages. and posted respectable alphas and information ratio but still would have lost 40% of its value. If the long-term average return on an investment was 8% annually, how close was that investment to 8% each and every year? If the investment always Swan Global Investments | 970-382-8901 | swanglobalinvestments.com New Risk Metrics for a New World 4 3. Capital Preservation since the Great Depression. Quantifying tail risk When most investors think of risk, they most is difficult, but there have been some innovations likely define it as simply “not losing money.” The on this front. idea of maximizing the excess return-vs-tracking The StatMAP error relationship takes a backseat to not losing 30%, 40%, or 50% of one’s wealth. Because The grid below combines these concepts along this is close to how most investors consider two axes. At Zephyr, we called this “the StatMAP.” risk, ways of quantifying risk in terms of capital Most of the performance and risk metrics fall preservation represent the next generation in risk neatly into this grid. and performance measurements. There are certainly more performance metrics out there, but most of them would fit somewhere 4. Tail Risk within this framework. The ones explored in this Closely related to capital preservation is the risk of paper are highlighted in blue. The two right-most extreme, outlier events. Commonly known as “tail columns, Capital Preservation and Tail Risk, are risk” or “black swan” events, they are marked by the focus of the post-MPT discussion, but the their rarity and severity. The scope and scale of first two measures discussed are those of capital the Financial Crisis of 2007-09 had not been seen preservation. Volatility Risk Benchmark Risk Capital Preservation Tail Risk Risk Return Excess Return Skewness Batting Average Upside Omega Up Capture Risk Standard Deviation Beta Maximum Drawdown Kurtosis Downside Deviation R-squared Pain Index Value at Risk Tracking Error Conditional Value at Risk Down Capture Downside Omega Return/Risk Sharpe Ratio Alpha Calmar Ratio Omega Trade-off Sortino Ratio Information Ratio Pain Ratio Zephyr K-ratio Treynor Ratio Table 1. Source: Swan Global Investments. Swan Global Investments | 970-382-8901 | swanglobalinvestments.com New Risk Metrics for a New World 5 MEASURES OF CAPITAL PRESERVATION: PAIN INDEX & PAIN RATIO The graph below shows the drawdown of the 2003 when the market lost 44.73%? What about S&P 500 over the last 20 years. The maximum some of the smaller, shorter dips? How long did drawdown can be seen as -50.45% starting in it take for the market to recover all of its losses? November 2007 and eventually bottoming out Those questions are not answered by maximum by February 2009. But what about the previous drawdown. They are, however, answered by a bear market, the one from March 2000 to March metric called the pain index1. Drawdown July 1997 - June 2017 0% -10% -20% -30% -40% -50% Jun 1997 Dec 1999 Dec 2004 Dec 2009 Dec 2014 Jun 2017 S&P 500 CreatedChart with 1.Zephyr Source: StyleADVISOR. Zephyr Manager returns StyleADVISOR supplied by: Morningstar, Inc. 1 The pain index and the pain ratio were developed by Dr. Thomas Becker and Aaron Moore of Zephyr Associates in 2006. http://www.styleadvisor.com/ sites/default/files/article/zephyr_concepts_pain_ratio_and_pain_index_pdf_18774.pdf Swan Global Investments | 970-382-8901 | swanglobalinvestments.com New Risk Metrics for a New World 6 The Pain Index that an investment had never lost a penny over If one were to fill in the entire area between the the time period in question.