#sharperatio #sortinoratio #treynorratio

In this video we will learn how to calculate the most used metrics to analyse hedge funds' performance and make informed investment decisions.

The metrics which are most used by analysts are: Sharpe ratio, Sortino ratio, Treynor ratio and Information Ratio.

Sharpe, Sortino and Treynor ratio all have the same numerator, i.e. the average excess return of the fund compared to the risk-free rate (approximated, as usual, by short term yields on government bonds), but these ratios have different denominators.

The Sharpe ratio compares the excess return of the fund to its total risk, as measured by the standard deviation. The Sortino ratio uses Downside deviation which is the standard deviation of negative returns only. The Treynor ratio compares the excess return to the fund's market risk as measured by the Beta of the fund.

The Information ratio compares the average return of the fund to a discretionary benchmark. This benchmark can be a passive index that the manager is trying to outperform, or it can be the average of the fund's competitors. This excess return is divided by the tracking error, which technically measures the standard deviation of the difference in returns between the fund and its benchmark. The tracking error gives us a measure of active risk run by the manager as it tells us how far from its competition the fund is positioning over time.

Analysts tend to use the Sharpe ratio if they believe that standard deviation is an appropriate measure of risk, this will be situations where we have both systematic (market) risk and idiosyncratic (asset specific) risk. If systematic risk has been diversifier away, the Treynor ratio might be a more appropriate measure of excess return per unit of risk since it only uses the Beta which measures market risk.