Manager Builds a Better Metric

The manager of a statistical-arbitrage fund has developed a measure of risk-adjusted returns that more accurately reflects the risks of investing in hedge funds than the widely used Sharpe ratio.

Logica Capital, a Los Angeles firm with $15 million under management, has shared its “skill metric” with several dozen institutional investors in the past week, telling them it offers a truer picture of a fund’s risk-adjusted performance than commonly used measures including the Sharpe and Sortino ratios. A well-known deficiency of the Sharpe ratio is that it doesn’t adequately capture the risks of portfolios whose return distributions are negatively skewed — an indicator of downside volatility. That includes most hedge funds.

“Assuming that an asymmetric distribution is symmetric when it is [negatively] skewed will cause any model to dramatically understate risk,” Logica chief investment officer Wayne Himelsein and research chief David Taylor wrote in a white paper titled “The Illusion of Skill” outlining the methodology for their skill metric. “We posit that if investors actually observed the true risk levels, relative to the respective reward of a potential investment, they would alter their allocation behavior.”

Analyzing historical return data from HFR, Himelsein and Taylor calculated that all but one major hedge fund strategy are negatively skewed, with multi-strategy funds, credit-arbitrage vehicles and volatility strategies displaying the highest degrees of “skewness.” The only positively skewed strategy is global macro.

Logica’s skill metric is designed to account for the higher volatility inherent in most hedge fund portfolios, whose return streams tend to be marked by occasional steep drawdowns. Applying the measure to 17 years of return data, Himelsein and Taylor found it produced substantially lower reward-risk ratios than Sharpe — at least 60% lower for funds in the HFRI Relative Value Index, HFRI Multi-Strategy Index, HFRI Credit Arbitrage Index, HFRI Fixed Income-Corporate Index and HFRI Credit Index. The HFRI Fixed Income-Asset Backed Index has a relatively strong Sharpe ratio of 2.21, but its skill metric is just half that measure.

“Overall, Sharpe ratios contract dramatically when adjusting for negative skewness, highlighting that allocators should broadly revise their expectations,” Himelsein and Taylor wrote.

Among the investors who have been shown Logica’s ratio is Jonathan Dane, who oversees investments at $800 million multi-family office Coury Investment. He said he plans to begin incorporating the skill metric into his analysis of hedge funds and other investments. “We know the returns aren’t normally distributed and we know tail events happen more than they should,” Dane said. “When I look at funds, I spend a ton of time with Sharpe ratios, volatility and standard deviations, rolling returns, max drawdowns and return distribution. What Wayne [Himelsein] has done is create an elegant way of taking these tail-risk events, allowing you to make an apples-to-apples comparison across strategies.”

The idea of the skill metric grew out of Himelsein and Taylor’s experience designing and running their Logica Fund. Their goal was to create a portfolio whose returns were normally distributed — that is, not skewed either positively or negatively. They appear to have succeeded. The fund’s skill metric is identical to its Sharpe ratio, which is what you would expect in the case of a normal distribution.

Since its inception in January 2015, Logica Fund has generated a gross annualized return of 8%.

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Because of the stay-at-home order and related effects of COVID-19, Logica was unable to meet the original filing deadline for its ADV, and relied on the SEC CV-19 order to file by the extended deadline.

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