Standard Deviation how managers mislead

CFA Level III
#1

Hi all,

I’m looking for a particular section of the CFA materials which talks about how hedge fund managers use of standard deviation can be misleading. I think it was in Level III but not completely sure. Can anyone point me to where in the materials this is? I can’t seem to find it.

Thanks!

#2

there is mention of use of appraisal data for alternative investments - which leads to a reduction in the standard deviation and hence an increase in Sharpe ratio if that is used as a performance measure. (Capital Markets Reading).

#3

You might also want to check out Global Performance Evaluation, specifically the section entitled “Some Potential Biases in Return and Risk”.

#4

I think this is all over the place. In risk, while discussing the strengths of the different types of Var, it’s mentioned that it’s not appropriate to use Analytical Var for securities with option-like behavior (not normal). I think the same point is even made in Behavioral Finance somewhere.

I think the closes thing to a list is the ways in which managers can game the Sharpe Ratio (and all of them are ways to game standard deviation). I don’t remember where this is (I’d look in equities or maybe risk). It goes something like:

  • lengthening the measurement interval

  • smoothing of returns (like appraisals for illiquid assets)

  • eliminating extreme returns (like swapping the best and worst returns against the index)

  • writing out-of-the-money options or any kind of catastrophe event

Opinion: The first two are somewhat easier to spot, so we must compare apples to apples. The elimination of extreme returns may be OK if its a regular part of the process and that’s what the client wants (after all they really are getting less volatility).

I think the most important one to always have in the back of the mind is the tail risk/catastrophe event stuff. Those are often legit strategies (writing options may look like easy money). The mean will be improved, and the standard deviation may be improved as well. As long as the calls are kept out-of-the-money, the manager generates steady profits. If something happens and they all get in the money (puts in a crash) the fund may be wrecked.

The famous LTCM fund broke in a way akin to that. They did extremely levered arbitrage and were almost always right. Amazing Sharpe, until they blew up.

#5

See Volume 5 of Level 3 - Alt. Investments, Risk Management and the Application of Derivatives.

In Alternative Investments Portfolio Management - Hedge Funds section, page 80-81.

Sharpe Ratio limitations for hedge fund investors

  • Time dependency (ratio increases propertionally with square root of time)
  • Not appropriate for asymmetrical return distribution (i.e. Hedge Funds)
  • Illiquid holdings = upward bias
  • No consideration of the correlations of other assets in portfolio

Sharpe Ratio can be gamed by:

  • lengthening measurement interval
  • writing out of money puts/calls
  • smoothing returns
  • eliminating extreme returns
#6

It’s in altern investment section, and it sayshedge funds usually use derivatives and their return dist is skewed…Say, probaility of an extreme outcome is higher than that indicated by standard deviation. Basically Stn Dev. underestimates the risk of a hedge fund