Sharpen Sharpe Ratios

In this previous post, I discussed some of criticism of sharpe ratios and particularly the focus on investors and prospective employers on a certain sharpe ratio. The problem with sharpe is it assumes ‘normal’ distribution of returns (return / std. dev of returns). This unfairly penalizes large percentage positive returns.

The good guys at the Yale School of Management wrote a paper and presentation on a method to manipulate or artificially boost the Sharpe Ratio of any strategy, useful for marketing purposes. It simply takes the existing portfolio and sells OTM Calls and Puts on the holdings or a corresponding index. This has the effect of cutting off the large positive portion of the return distribution and elongating the tail on the negative end:

ScreenHunter_03 Nov. 08 21.00

If we break this down synthetically, the portfolio is actually long stock, short strangle. Further breaking it down, the long stock, short call is equivalent to a naked put, plus the additional naked put, the strategy is equal to short multiple naked puts. Amazing isn’t it?? Part of the presentation mentions a fund called Integral Asset Management which managed money for the Art Institute of Chicago and proceeded to lose ~$50MM dollars. The managers in question probably retained a nice 2% fee and 20% performance fee for losing a ton of money. How would you like to get paid to lose money? I would, I would! lol.

I also had experience with a recent short premium CTA, Zenith resources. The managers had an amazing fee arrangement, they charged 0% management fee and 30% performance fee. Brilliant! Your investors suspect the fund is confident enough in their ability to achieve a return that it forgoes a management fee. Meanwhile the manager actually just got their hands on a potentially very valuable call option. And the SEC is worried about insider trading, ha….

~ by largecaptrader on November 8, 2009.

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