Risk-adjusted performance measures are generally considered to be appropriate for use in the evaluation of different investment strategies and for making comparisons between them. This issue of The Journal of Risk contains papers that address related estimation challenges as well as enhancements that account for realistic features and the regulatory environment.
The first paper in the issue, "The Sharpe ratio efficient frontier" by David H. Bailey and Marcos López de Prado, addresses the estimation accuracy of the Sharpe ratio. In the presence of nonnormal and nonidentically distributed returns, the standard estimation technique is known to produce inflated values. The authors propose a corrective metric, the probabilistic Sharpe ratio, that is also useful for detecting evidence of a fund manager's skill. They develop the concept of a Sharpe ratio efficient frontier to determine the maximum expected Sharpe ratio for a given level of statistical inaccuracy.
The issue's second paper, "A variational derivation of risk-adjusted performance measures" by George Xiang, Jiangyang Liu and Qi Wang, explores some theoretical features of alternatives to the Sharpe ratio. These are particularly important when returns are nonnormal, and the authors show that they are very useful in accounting for the different ways in which an investment is funded.
In the third paper in this issue, "The importance of attributing active risk to benchmark-relative sources" by Ben Davis and Jose Menchero, the authors highlight the importance of attributing active risk and return to the same sources. They also argue that, for active managers, these return sources should be based on relative benchmarks and should illustrate how the use of a marginal contribution to active risk results in consistent and intuitive effects across securities, sectors and factors.
The issue's fourth paper, "Are real investment decisions based on risk-adjusted performance measures consistent with maximizing shareholder value?" by Niklas Lampenius, addresses capital budgeting at the firm level. In the context of portfolio allocation across real investment projects, risk management visibility has increased significantly because of the heightened regulatory attention brought about by implementation of the Basel accords. The author argues that risk-adjusted performance measures that explicitly account for safety-first criteria decrease the cost of debt for a firm.
The fifth and final paper in this issue, "Risk sharing and individual life-cycle investing in funded collective pensions" by Roderick D. J. Molenaar and Eduard H. M. Ponds, was accepted by Paul Cox for a special issue of The Journal of Risk (Volume 13, Number 3) but did not appear for logistical reasons. It focuses on cost-efficiency and intergenerational risk sharing by accounting for both optimal individual life-cycle and collective pension fund benefits.
Are real investment decisions based on risk-adjusted performance measures consistent with maximizing shareholder value?