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So one improvement we can make over the Sharpe ratio is the so-called

Treynor ratio.

How is it computed?

Well, you see that the numerator is actually the same at the Sharpe ratio.

It's the excess return over the risk-free rate, Rf.

It's the denominator that changes and we see here beta i,

which is the beta of portfolio i or asset or fund.

Why do we take the beta here?

Well, the reason is simple.

Actually, Mr. Treynor believed that you should

only be rewarded for the non-diversifiable risk.

Do you remember this chart?

We saw it previously.

It shows the evolution of the total risk of a portfolio,

as a function of the number of stocks you include in a portfolio.

You see that the more stocks you include in a portfolio, the lower the total risk.

Why?

Because basically, the more stocks you add,

the more diversification you bring in your portfolio.

And hence, you're able to reduce,

you're able to diversify away the part of the risk,

which is diversifiable by adding more stocks.

And basically, in the end after a certain number of stocks,

here the estimation is that at roughly 25 stocks you're

only left with market risk i non-diversifiable risk and

that's the beta of your portfolio.

And hence, this is the part of the total risk, which you be rewarded from.

It's the risk, which you cannot diversify away.

And this is why Treynor doesn't look at the whole risk of the portfolio,

but only the market risk.

So, this is the measure used by Treynor.

A very recent study published in April 2016 in the Journal

of Economic Literature by this Mr. Javier Vidal Garcia made

an interesting analysis of comparing various measures,

the Sharpe, the Treynor as well as others, the Modigliani squared.

And basically, what he came up with the result is that you have

different measures clearly, but the ranking, what he did.

He looked at the sample of more than 16,000 actively

managed funds worldwide and the conclusion is that,

basically, the ranking does not change.

And so, the Sharpe ratio provides a very good measure for

ranking the best funds in terms of risk-adjusted returns.

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But now, we need to look at another improvement of the Sharpe ratio and

this is provided by the Sortino and

we'll see why this measure is actually more suitable for

hedge funds than for traditional money managers.

The Sortino ratio is computed likewise, you see here the formula.

Basically, the main difference between the Sortino and

the Sharpe ratio is here again, the denominator.

The numerator is the same.

Excess return over the risk-free asset.

The denominator is different.

And here, we're talking about downside deviation.

Now, what is downside deviation?

Basically, it's the deviation,

it's the volatility measure to the left of your distribution.

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Assume you are managing a fund and

you are my customer and I promise you,

I say, I have a target return of 12%.

In one year's time, my return,

the return of your fund you bought from me is actually 35%.

I promise I would give you 12% and I come up with 35%.

I bet you're not going to call me and say, what did you do?

This is a higher volatility with this 35%.

It deviates so much from what you promised,

from the average that [LAUGH] this is increasing my volatility measure.

Not many people are going to complain about this kind of volatility,

if it's to the right of the average.

But if It's to the left, if I promise 12% and

in 12 months time, I deliver minus 28.

I bet I'm going to get some nasty call from you and

say, hey, what's going on here?

So just to say, just to illustrate that.

We care much more about subpar volatility,

about below average volatility than above average volatility and

this is precisely what this downside volatility measure aims at capturing.

Going back to the example we saw of ice creams and umbrellas.

We see here that the Sortino ratio also speak for

the long-short strategy, the last one.

The long ice cream, short umbrellas.

You see that's 1.58.

So, here is what we do is we take the performance.

We compute the performance over the risk-free return of 1% and

we divide not by the volatility, but the downside volatility, i.e,

14.9 and we see that is highest with the for this long-short strategy.

And indeed, the Sortino ratio is the ratio,

which is most widely used when we look at head funds.

Because clearly there, we have here a kind of asymmetry

that hedge funds should be delivering good returns and

should be striving for absolute returns, i.e.

Basically, they have this asymmetric attitude towards risk.

Take more risk when they think the market is going up and

hedge away some of the risk, either by raising the bucket of short positions or

by taking some hedging against the market falls when they expect marker turmoil.

And so, this is why the Sortino ratio is actually more usable to measure

the risk-adjusted returns when we're dealing with hedge funds.

So in conclusion, the Sharpe ratio is the most wildly used measure and

we'd see with the study that we are a quoted here that it

actually gives the best possible result when we need to

rank funds by their risk and return characteristics.

We may improve the Sharpe ratio by taking into account

the fact that the distribution of returns may not be normal and

may have the skewness and kurtosis or there are measures that are adjust for

this kind of deviation from a normal distribution.

But all in all, I would say that the Sharpe ratio provides a very good first

measure and a good proxy to use when you want to assess the risk-adjusted returns.

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