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Investors typically use performance benchmarks such as the Sharpe ratio or Sortino ratio to rank mutual funds, ETFs and index trackers. However, these general performance benchmarks have many drawbacks and can often be very misleading. The Omega Ratio overcomes these shortcomings and provides a more sophisticated method of ranking investments.
The Sharpe ratio originated in the 1960s and is also known as the reward-to-risk ratio. It is a fund’s effective return divided by its standard deviation, and its primary advantage is that it is widely given in fund data sheets. Standard deviation is employed by the Sharpe ratio as a proxy for risk. However, this is misleading for several very important reasons.
First, standard deviation assumes that investment returns are normally distributed. In other words, returns have a classic bell-shape. For many investment vehicles, this is not necessary. Hedge funds and other investments often exhibit skew and kurtosis in their returns. Skewness and kurtosis are mathematical terms that denote a distribution that is wider (or narrower) or taller (or shorter) than is typical of a normal distribution.
Second, most investors think of risk as the probability of loss – in other words the size of the left side of the distribution. This is not what is represented by the standard deviation, which simply indicates how widely spread investment returns are around the mean. By removing information from the empirical return distribution, standard deviation does not adequately represent the risk of making excessive losses.
Third, the standard deviation punishes variation above the mean and variation below the mean equally. However, most investors only worry about variances below the mean, but positively encourage variances above the mean. This point is partially addressed in the Sortino ratio, which is similar to the Sharpe ratio but only penalizes negative deviations.
Finally, historical averages are used to represent expected returns. This is again misleading because the average gives equal weighting to returns in the distant past and returns in the recent past. The latter are better indicators of future performance than the former.
The omega ratio was developed to overcome the failures of the Sharpe ratio. The omega ratio is defined as the area of the return distribution above a threshold divided by the area of the return distribution below the threshold. In other words, it is the probability-weighted upside divided by the probability-weighted downside (a higher value is better than a lower value). This definition elegantly captures all the important information in the return distribution, and more importantly adequately describes the risk of making excessive losses.
However, an investment with a high Omega ratio can be more volatile than an investment with a high Sharpe ratio.
sharpe ratio and both omega ratio Calculations can be easily performed using tools such as spreadsheets or other math packages.
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