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Alternative Market Briefing

Academic finds Sharpe ratio et al wanting in measuring hedge fund performance

Monday, April 29, 2013

Beverly Chandler, Opalesque London: Marcos Lopez de Prado of Hess Energy Trading Company, Lawrence Berkeley National Laboratory has published a paper entitled The High Cost of Simplified Math: Overcoming the 'IID Normal' Assumption in Performance Evaluation.

Lopez de Prado finds that investment management firms routinely hire and fire employees based on the performance of their portfolios, and lists the methods of measuring that performance as popular metrics that assume IID Normal returns, such as Sharpe ratio, Sortino ratio, Treynor ratio, Information ratio and so on.

He finds that investment returns are far from IID (Independent and Identically Distributed) Normal. Lopez de Prado says: "Firms evaluating performance through Sharpe ratio are firing up to three times more skilful managers than originally targeted. This is very costly to firms and investors, and is a direct consequence of wrongly assuming that returns are IID Normal."

He finds that an accurate performance evaluation methodology is worth a substantial portion of the fees paid to hedge funds. "There is a 20% loss of the drawdown for every false positive. For a large firm, this amounts to tens of millions of dollars lost annually, as a result of wrongly assuming that returns are IID Normal."

In cases with first-order serial correlation, Lopez de Prado finds that the Maximum Drawdown is generally greater ......................

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