Morningstar Magazine - April/May 2018 - 38

Strategies

Low Volatility's Unexpected Risk
Standard risk measures miss its extreme
downside potential.
Tax Wise
	

42

Who Should Inherit Your Client's IRA?

	

46

Lies, Damn Lies, and Statistics

RESEARCH

James X. Xiong and Thomas M. Idzorek

Quant U

Investment Research
	

48

Artificial Intelligence Takes Off

	

51

	

52

	

53

Manager: A Moderate Take on
High Income
Passive: A Better Bogy
Equity: Premier Player

Best Ideas

Many investors will be surprised to learn that low
volatility tends to be accompanied with an
undesirable risk characteristic: negative tail risk, as
measured by skewness. A stock or fund can
rank well based on the standard Sharpe ratio but
poorly on enhanced tail-risk-based Sharpe
ratios that account for non-normal returns, and
vice versa.
The Sharpe ratio-defined as the excess return
divided by the standard deviation (of the excess
return)-measures how well the return of
an asset compensates the investor for the risk
taken. The asset with a higher Sharpe ratio
provides better return per unit of risk. However,
the standard Sharpe ratio (Sharpe, 1966, 1994) has
limitations. When returns are not normally
distributed, as they often are in the real world,
standard deviation (or volatility) is an incomplete
measure of risk because it fails to pick up tail risk.

The limitations of standard deviation are becoming
more well-known and have led practitioners
to embrace measures such as conditional value at
risk, or CVaR. Yet, when it comes to measuring
risk-adjusted performance, practitioners have
largely failed to move to superior risk-adjusted
measures that account for non-normal returns. The
Sharpe ratio remains the most widely used
measure of risk-adjusted performance. Investors
often use the Sharpe ratio to evaluate and
compare the performance of investment
portfolios, so it has a powerful impact on fund
flows, investment decisions, asset allocation,
and risk management.
Researchers have proposed several alternatives
to the standard Sharpe ratio ( EXHIBIT 1 ).
They differ only in the risk measure (the ratios'
denominator). The Sortino ratio (Sortino and
Hopelain, 1980) uses semivariance, or
semi-standard deviation, which measures the
volatility of only negative returns. The Treynor ratio
(Treynor, 1965), uses the portfolio's beta,
which focuses on the investment's systematic risk.

EXHIBIT 1

Alternative Risk Measures The Sharpe ratio gives an incomplete definition of risk.
Researchers have developed several superior risk-adjusted performance measures,
including two that are tail-risk-based: the CVaR and MDD ratios.
Performance Measure

Risk Measure

Source

Sharpe Ratio

Standard Deviation

Sharpe (1966, 1994)

Sortino Ratio

Semi-Standard Deviation

Sortino and Hopelain (1980)

Treynor Ratio

Beta

Treynor (1965)

CVaR Ratio

CVaR

Rachev, Martin, and Siboulet (2003)

MDD Ratio

Maximum Drawdown

Young (1991)

Source: Morningstar.

38

Morningstar April/May 2018



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