Reading 37: Risk Management －LOS l contrast, measures, capital

cfaedu

CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 12: Risk Management
Reading 37: Risk Management
LOS l: Compare and contrast the Sharpe ratio, risk-adjusted return on capital, return over maximum drawdown, and the Sortino ratio as measures of risk-adjusted performance.

cfaedu

Jenny Rouse has been a portfolio manager for Theta Advisors for the last five years. The performance of her portfolio has had few returns below its benchmarks since its inception. Which of the following risk measures best measures Rouses performance?

A) Sortino ratio.

B) Standard Deviation.

C) Range.

D) Sharpe ratio.

---

Answer and Explanation

The Sortino ratio examines the downside risk of returns. It is calculated as the portfolio return minus the minimum acceptable return (MAR) divided by a standard deviation that only uses returns below the MAR. It is similar to the target semivariance. Since Rouses portfolio has had consistently higher returns, she should not be penalized for any variability on the upside. The range (the difference between the highest and lowest values), standard deviation, and Sharpe ratio (which uses the standard deviation in the denominator) examine all returns, whether they correspond to positive or negative alphas. The use of these measures would result in risk measurements that are unfairly high in Rouses case.

cfaedu

In the Sortino ratio, the excess return is divided by the:

A) standard deviation.

B) standard deviation using only the returns below a minimum level

C) maximum drawdown.

D) VAR.

---

Answer and Explanation

The Sortino ratio examines the downside risk of returns. It is calculated as the portfolio return minus the minimum acceptable return (MAR) divided by a standard deviation that only uses returns below the MAR. It is similar to the target semivariance. The other responses refer to other measures of risk-adjusted performance. The Sharpe ratio divides the excess return above the risk-free rate by the standard deviation. An example of a risk-adjusted return on invested capital (RAROC) measure would be to divide the portfolios expected return by the VAR. The RoMAD (return over maximum drawdown) is the average portfolio return divided by the maximum drawdown. Drawdown refers to the percentage difference between the highest and lowest portfolio values during a period.

cfaedu

Which of the following risk measures does NOT assume a normal distribution of returns?

A) Standard Deviation.

B) Sortino ratio.

C) Sharpe ratio.

D) RoMAD.

---

Answer and Explanation

The RoMAD (return over maximum drawdown) is the average portfolio return divided by the maximum drawdown. Drawdown refers to the percentage difference between the highest and lowest portfolio values during a period. For example, if the maximum portfolio value during a year was $1000 and the minimum was $900, the drawdown would be 10% [($1000-$900)/$1000]. This measure does not make an assumption of normality in the returns. The standard deviation and Sharpe ratio (which uses the standard deviation in the denominator) both assume a normal distribution of returns. The Sortino ratio examines the downside risk of returns and also assumes a normal distribution of returns.