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Market Volatility Doesn't Matter
By Mel Miller

From reading the headline, you might jump to the conclusion that the cheese has finally slipped off Mel’s cracker. Or it might lead you to think that Mel doesn’t have any direct clients or he would not make that statement!

You would be wrong. I’m Mel Miller, and in my career, I have been the advisor for hundreds of clients as Chief Investment Officer of the trust Department at Dubuque Bank and Trust. I learned that individuals and organizations view volatility differently than the academic community.

The academic community talks in terms of the Capital Asset Pricing Model (CAPM). Return is not viewed as absolute but must be adjusted for risk. Risk is defined as standard deviation or volatility.

The Sharpe Ratio is the ultimate measure as it adjusts the returns for volatility to arrive at a risk-adjusted return. Fund and portfolio manager rankings are based on the ability to produce the highest Sharpe Ratio. So, why wouldn’t clients view the Sharpe Ratio as the best method of analyzing the portfolio manager’s performance?

The CAPM and the corresponding Sharpe Ratio is based on a premise that all volatility is equal—a premise not shared by most clients. Occasionally an institutional client would be satisfied utilizing the Sharpe Ratio to measure relative performance, but it was a rare thing.

Upside and downside volatility are not the same in the minds of most clients. The vast majority of clients viewed downside volatility more importantly than upside volatility. In fact, nobody cares about volatility in an up market, only in a down market. So, what is a better measure of how clients view risk?

The Sortino Ratio only adjusts for harmful (downside) volatility. The formula looks virtually the same as the formula for calculating the Sharp Ration except the denominator is only the standard deviation of negative asset returns. The higher the Sortino Ratio the better. Let’s look at an example.

The exhibit below presents the performance information for a certain high performing bond fund that is utilized by First Affirmative in many client accounts. Notice the Bloomberg performance rankings on the left. The fund has outperformed 97% of its peers so far in 2014, 97% over a one year period, and 98% over a three year period.

The right side of the page presents various risk-adjusted measures. Over the last year the Sharpe Ratio out performance is impressive. But more importantly—in the mind of most clients—is the out performance of the Sortino Ratio. The relative out performance is greater in a negative (rising interest rates) environment. Exactly what our clients want!

 

 

At First Affirmative, we understand that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?

Mention of specific companies or securities should not be considered an endorsement or a recommendation to buy or sell that security. Past performance is no guarantee of future results.

Posted: December 5, 2014