Wednesday, July 8, 2015

Zopounidis and Galariotis, Quantitative Financial Risk Management

Quantitative Financial Risk Management: Theory and Practice, edited by Constantin Zopounidis and Emilios Galariotis (Wiley, 2015) is a collection of 15 papers, written primarily by academics. The papers deal with five main topics: supervisory risk management, risk models and measures, portfolio management, credit risk modeling, and financial markets.

One paper that I think should be of general interest to investors is William T. Ziemba’s “Portfolio Optimization.” Ziemba argued in 2005 that the Sharpe ratio needed to be modified to evaluate properly the returns of great investors since the ordinary Sharpe ratio penalizes gains. The modified measure (DSSR—downside symmetric Sharpe ratio) uses only losses to calculate the denominator.

So what kinds of DSSRs do the great investors/traders have? Berkshire Hathaway’s is 0.917. Compared to four other funds (Quantum, Tiger, Windsor, and the Ford Foundation), it has the highest monthly gains but also the largest monthly losses. “It is clear,” the author writes, “that Warren Buffett is a long-term Kelly type investor who does not care about monthly losses, just high final wealth.”

By comparison, “the great hedge fund investors [Ed] Thorp at DSSR = 13.8 and [Jim] Simons at 26.4 dominate dramatically. In their cases, the ordinary Sharpe ratio does not show their brilliance. For Simons, his Sharpe was only 1.68.” Be careful, however, what you wish for. One fund that the author studied had an infinity DSSR. “That one turned out to be a Madoff-type fraud!” (pp. 203-204)

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