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Hedge Funds 38 but the macro fund is not. This shows how much caution is necessary when making these performance assessments. The use of historical volatility for risk adjustment and the quest for stability is evident in the misuses of one of the most commonly used risk statistics in the Alternative Investment industry, the Sharpe Ratio (Sharpe, 1994). It is calculated as: Sharpe Ratio = Excess Return over Risk Free Rate Volatility Of Returns In layman’s terms, this is simply the excess return divided by the volatility of returns. Three major methodological issues loom large. While the cottage industry of information that feeds the information food chain surrounding Alternative Investments may not be very concerned about them, they nevertheless deserve attention: • As clearly indicated by William F. Sharpe himself, the ratio was designed for static portfolios, notably mutual funds. This is hardly the case with the intense portfolio rebalancing that is one of the hallmarks of hedge funds. Active portfolio management being the undisputable style feature of hedge funds, it is puzzling why investors use a risk indicator that is more reflective of passive portfolio management. • The ratio attributes equal weighting to up- and downside volatility, thereby penalizing hedge fund styles that aim for asymmetrical returns, typically with directional option strategies. • The incentive may be there for managers to construct portfolios that display a high Sharpe Ratio prior to mean reversion in returns, ie, the occasional large loss. Goetzmann et al. (2002) have explored the use of option-like strategies to devise high-Sharpe Ratio “It is dangerous to use the frequency of returns as a proxy for probability assessments.” portfolios irrespective of the manager’s skill. Few practices – irrespective of how widespread they are – are as dangerous as the use of the Sharpe Ratio as a mechanical pre-screening tool device for hedge fund managers. Given the crude volatility methodology illustrated above, there is a potential adverse selection and survivorship bias issue. This is because funds with high positive volatility would be as likely to get screened out as funds with high volatility resulting from drawdowns. Other measures, such as the Sortino Ratio have been devised in order to address the issue above. Risk Management Risk Management and Risk Monitoring The following table compares some of the key attributes that one may encounter in different risk operations. Some larger organizations may of course be more structured and feature specialists to cover both functions. This comparison is not intended to diminish the importance of getting reliable information, quite the contrary. Rather, it provides a quick acid test of how much independent risk thinking exists in a fund. Let’s face it, traders are not often quoted as examples of moderation in their egos. Not all of them have enough emotional intelligence or patience to select and hire independent thinkers! Conclusions What issues should top investors’ lists when talking about risk? 1) “Carry” or “Arbitrage” strategies that produce frequent positive returns and event risk exposure are opposite sides of the same coin. If one gets paid Risk Monitoring Objective Use and interpretation Provision of information of information Time orientation Mostly forward-looking Mostly backward-looking Key question How/why may the portfolio How can the historical change in value? performance be attributed? Philosophy 80% decision-making-20% 80% productionproduction 20% decision-making Ideal type of Direct Trading & Investment Product Control & previous experience Management experience Risk Monitoring SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
“ ‘Carry’ strategies and event risk exposure are opposite sides of the same coin.” Hedge Funds on an ongoing basis for an extended period of time, there is always some fundamental bet underlying the strategy. On this basis, one should rather classify strategies as risk insurance buyers versus risk insurance sellers and understand the mix between these two categories in one’s portfolio. 2) Bear in mind that hedonic framing pushes motivates investors towards more frequent positive returns and most insurance-buying strategies will experience losses most of the time and positive payoffs only occasionally. These factors will push investors to be systematically overweight in insurance-selling strategies. Rather than fooling themselves into illusions of stability of their returns and confusing luck with skill, investors would be well advised to manage that insurance mix more consciously. 3) Having a computer and/or a person supply the figures regularly is a necessary but not sufficient condition to conclude that a Fund has a Risk Management function with teeth. Some “creative tension” between risk and trading functions inside a Fund is something that any intelligent investor should be actively looking for. 4) If the Fund in which you are considering an investment leans more towards hiring “reporting” types, you should find out where is the added value of having a person provide what a good computer should fetch anyway. It may help reveal some unwillingness to invest in adequate computer/risk infrastructure and underscore other operational weaknesses. All the caveats raised in this article may not necessarily be what a short-term oriented marketer wants to hear. Calling a spade a spade, though, is at the heart of stronger quality control in the products offered to investors and in cementing longer-term relationships with them. Markets and probabilities eventually catch up with most short-term marketing shortcuts anyway. References Celati, L. (2004), Chapter 7, The Dark Side Of Risk Management, FT/Prentice Hall, London. Goetzmann, W., Ingersoll, J., Spiegel, M. & Welch, I. (2002), Sharpening Sharpe Ratios, Working Paper. Kahnemann, D., Tversky, A. (1974), Judgment under Uncertainty: Heuristics and Biases, Science 1974, 185, 1124– 1131. Kiev (2002), The Psychology of Risk, Wiley, New York, p. 4. Sharpe W.F. (1994), The Sharpe Ratio, Journal of Portfolio Management. Thaler (1985), Mental Accounting and Consumer Choice. Journal of Economic Behaviour and Organization 1, 39–60. Thaler (1999), Mental Accounting Matters. Journal of Behavioural Decision-Making 12, 183–206. Hedge Fund indices and returns can be found on: www.hfr.com and www. edhec-risk.com Luca Celati is the co-Founder of Abraxas Capital Management, the London-based Investment Manager of Abraxas Fund, a Long-Gamma hedge fund. He can be reached at celati@abraxasfund.com The Author would like to thank Ms. Mara Airoldi for the kind support provided in the correlation study. 39 SWISS DERIVATIVES REVIEW 26 – NOVEMBER 2004
Page 1 and 2: SWISS DERIVATIVES ISSUE 26 - NOVEMB
Page 3 and 4: Contents Contents SWISS FUTURES AND
Page 5 and 6: Dear Members and Friends of SFOA Ed
Page 7 and 8: Focus Treasury. Then came Ginnie Ma
Page 9 and 10: “This approach moves us in the di
Page 11 and 12: WHEN YOUR FIRST NAME IS “NEW,”
Page 13 and 14: Focus Union’s regulators in terms
Page 15 and 16: “There’s no rule saying banks c
Page 17 and 18: The rush of endless opportunity. Li
Page 19 and 20: Further your future: team up with a
Page 21 and 22: “Investor interest in gold was re
Page 23 and 24: A new standard in the derivatives i
Page 25 and 26: “The Stone Age didn’t end becau
Page 27 and 28: A blazing sponsor for Friday night
Page 29 and 30: CNBC Europe reporting live from Bü
Page 31 and 32: A fascinating presentation by ballo
Page 33 and 34: “Swiss taxation is very advantage
Page 35 and 36: “These results seriously question
Page 37: D O W J O N E S I N D E X E S THE D
Page 41 and 42: Education Chart 2 Overbought zone (
Page 43 and 44: Bollinger Bands Let’s briefly rev
Page 46 and 47: Emerging Markets A Perspective on E
Page 48 and 49: Profile IFRI - The International Fi
Page 50 and 51: Profile 50 Official Publication of

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