The goal of defined benefit sponsors is to fund their plans within their cost constraints. The goal of a 401(k) participant is to retire at a certain age.
In both cases there is some return that must be earned at minimum to accomplish the investor's goal. If this minimal acceptable return, or MAR, is missing from your performance measure, the chances are you are helping someone else accomplish their goal, not yours.
An example of this problem can be seen in the "information ratio." The numerator consists of the active manager's return minus the return on a passive index. It provides information on whether the manager earned more than the passive index. Is that the goal of the investor, to beat an index? No, that's the goal of active portfolio managers, because that's how they get business from consultants. The investor's goal is not to get business for them; beating an index may or may not accomplish the investor's goal.
What is in the denominator of the information ratio? The deviations of the same thing that is in the numerator. It conveys information about whether the active manager is tracking the index. Suppose you are an active manager that consistently gets higher returns than the index. You will have a terrible tracking error. The more you outperform the index, the worse you will look. That could result in firing someone like Warren Buffett or Tony Browne. Of course, there aren't many managers like these, so the real problem is, the denominator does not contain the MAR. Therefore, tracking error cannot measure the risk of not accomplishing the investor's goal.
The information ratio conveys information that is relevant for most portfolio managers, but not investors who have to earn some MAR to accomplish their goals.
An alternative is the Omega Excess return, which is directly related to the investor's goal. It tells investors whether the manager beat a passive set of indexes after adjusting for the risk of not accomplishing their goals. It measures downside risk as deviations below the MAR. Furthermore, it factors in the investor's degree of risk aversion and the downside risk the manager took relative to the downside risk of a style benchmark. These are all things an investor should want to know.
For example, the Janus 20 Fund had a five-year unadjusted return of 29.6%. The downside beta indicates the fund took 10% less risk of falling below the MAR of 8.6% than a passive set of indexes that attempts to replicate the fund's style.
The Omega return says, after adjusting for all of the things mentioned above, it earned 26.4%. The Omega Excess indicates the fund earned 2.6% more than a passive strategy. The R-squared indicates the passive strategy accounts for 83% of the returns of the fund. While the calculations may be difficult, the numbers are easy to interpret.
Did it work better in the past than other performance measures? A study conducted by Bernardo Kuan of DAL Investment Co., San Francisco, showed Omega Excess returns had more predictive power than the Sharpe ratio, the Sortino ratio, or the information ratio for the 15-year period ended Dec. 31, 1997.
Also, it has a low correlation with the Sharpe ratio and the information ratio, indicating there is information in the Omega Excess not contained in the others. But, as reported last quarter, the top Omega funds did not do better than the Standard & Poor's 500 index in the horrible third quarter of '98 (Pensions & Investments, Nov. 16), although they did beat the median managed PIPER equity account of -14.3% by 430 basis points.
The Omega return is calculated in software provided by LCG Associates, Atlanta, and Mobius Group, Raleigh, N.C. The mutual fund data for the rankings and the model for calculating the statistics were provided by LCG Associates.
Frank Sortino is director of the Pension Research Institute, Menlo Park, Calif.
