Add omega excess return to the performance measurement tool box, right next to alpha.
The term alpha is used to denote the excess return a manager earned, over and above what the capital asset pricing model would predict. It is found by regressing the returns of the manager on the returns of the Standard & Poor's 500 Stock Index. When beta was at its peak of popularity, positive alphas were much sought after.
With the advent of style analysis, it is possible to calculate another type of excess return - omega excess.
A style benchmark is first created for each manager, identifying the percentage of the manager's return attributable to certain passive style indexes, e.g., large-capitalization value. Next, the omega return is calculated that adjusts for downside risk, the investor's degree of risk-aversion and the extent to which the manager took more or less risk than the benchmark. Third, the omega excess return is found by subtracting the omega return for the benchmark from the omega return of the manager. It is similar to alpha, in that it is a risk-adjusted return. It is different in that it is the excess return earned relative to the style benchmark, rather than the market index.
Preliminary evidence from our current research indicates added steps to calculate the omega excess are worth the extra effort. If a manager ranked in the first quartile based on the five-year omega excess return, how often did the manager remain in the first quartile one year later? To answer that question, we looked at all funds in the Pensions & Investments rankings that had been in business since 1977. Using a five-year interval to determine the style benchmark, the first ranking was for 1981. The graph above shows that 70% of the time, managers that began in the first quartile remained in the first quartile the following year, and only slipped to the fourth quartile 2% of the time. Conversely, fourth-quartile managers tended to remain in the fourth quartile in the following year (69%) and were least likely to shoot up to the first quartile (2%). We found the same results with three-year intervals.
No fund stayed in the first quartile every year, although Fidelity Magellan was there 14 out of the 16 years. Every manager except IDS New Dimensions went below the second quartile at least once. This suggests some strategy for switching could have been employed.
(For an explanation of the methodology used in the research, visit www.sortino.com.)
The mutual funds in the table on page 26 are ranked on the basis of five-year risk-adjusted return. The omega excess returns are shown using software developed at LCG Associates in Atlanta. Positive numbers indicate the fund outperformed a passive benchmark of style indexes. Negative numbers indicate the opposite. PBHG Growth was the only fund with a low R squared (0.68), which makes its top rating unreliable.
Frank A. Sortino is director of the Pension Research Institute, Menlo Park, Calif. The calculations were done with the help of Bernardo Quan at DAL Investment Co., San Francisco.