What are we evaluating?
Risk Management – Cause and Result
Joel Goldsmith is author of "A Parenthesis in Eternity". The Chapter quoted below is titled "The Un-illumined and the Illumined" page 157. He shares his perception of how spirituality developed over the ages.
"Two types of schools therefore developed side by side: Those that taught the power of the mind, and the purely spiritual that revealed how to unfold spiritually and develop a transcendental consciousness. On the level of mind, great works and great feats of magic can be performed, and sometimes this deludes people into believing that they are witnessing God in action, when it’s nothing more or less than action of the mind. IT IS VITALLY important that every aspirant on the spiritual path recognize and know the difference between these two approaches.
Whatever exists on the material and mental plane of life can be used in two ways, for good as well as for evil. The effects of spiritual or transcendental consciousness, on the other hand, can only be used for good."
Truth has no opposition - our material systems are all built using a mental level of consciousness therefore risk management applications may be used by some people with less than honorable intentions. Sometimes people unknowingly misuse applications and filters can be added to most risk management strategies that can prevent their ill-intended use. SafeMoneyMetrics® is one filter to be used for managed futures. It can be adapted to any investment that uses leverage. Time frame analysis using SafeMoneyMetrics® should probably be applied to any and all traditional investment portfolios. WHY?
Because volatility is here to stay – short term trading is more frequently employed – that means short-term positive results SHOULD be a by-product. Time frame analysis can probably benefit many equity investments that use high frequency trading.
Reward to Variability Ratio Definition (RVR)
According to Essentials for Investment by Bodie, Kane and Marcus, the RVR is traditionally used to measure investment returns relative to volatility of those returns. It is calculated by dividing the Risk Premium by the Standard Deviation (SD) of Returns. A Risk Premium is a return above the risk free rate of return.
SafeMoneyMetrics® Realized to Volatility Ratio Definition
We divide the Realized Ratio (capital at risk/ realized return) by the Standard Deviation of the Volatility Ratio and call it a Realized to Volatility Ratio. A Volatility Ratio is capital at risk /unrealized return.
50-50 |
RR |
VR |
NR |
Avg |
7.0% |
0.3% |
7.3% |
Max |
109.5% |
11.5% |
109.5% |
Min |
-65.9% |
-3.9% |
-65.9% |
SD |
25.21% |
2.25% |
25.45% |
RVR |
3.108 |
|
|
|
|
|
|
55-45 |
RR |
VR |
NR |
Avg |
7.7% |
0.4% |
8.0% |
Max |
118.6% |
12.6% |
118.6% |
Min |
-59.1% |
-4.3% |
-59.1% |
SD |
25.83% |
2.47% |
26.09% |
RVR |
3.109 |
|
|
We can then understand how volatility of unrealized returns translates into realized trading profits relative to capital at risk. A high ratio indicates lower risk. The data tables above and on the next page, represent four different allocations using two advisors. Look at the RVR (gray cells) relative to the AVG RR Column. The 60-40 Mix appears to have the greatest potential using this ratio.
60-40 |
RR |
VR |
NR |
Avg |
8.4% |
0.2% |
7.8% |
Max |
127.8% |
11.5% |
118.6% |
Min |
-52.3% |
-3.9% |
-65.9% |
SD |
26.62% |
2.31% |
28.22% |
RVR |
3.627 |
|
|
65-35 |
RR |
VR |
NR |
Avg |
8.5% |
0.4% |
8.9% |
Max |
136.9% |
14.9% |
136.9% |
Min |
-45.5% |
-5.1% |
-45.5% |
SD |
27.53% |
2.92% |
27.94% |
RVR |
2.897 |
|
|
An inherent weakness of the RVR Ratio as applied in our demonstration is that it only evaluates the summary of all data points and lives in isolation. To eliminate the weakness we can apply the exact RVR to annual returns, time frame analysis and a weighted average. The RVR as previously described then becomes part of the “Internal Benchmark” or reason we chose the advisor and/or constructed a portfolio using several advisors.
For more information on internal benchmarks read article # 32 Managed Futures – Benchmarks and SafeMoneyMetrics®
The graph above represents the Realized to Volatility Ratio (RVR) for the 60-40 Allocation over every 6,9,12 and 24 Month time period for the entire data sample. We now have partial “Benchmark Analysis” with a direct data foundation. In future articles we’ll describe how to evaluate negative returns and volatility using SafeMoneyMetrics®. Although past performance is still being used, we are moving forward in time and adapting the analysis to a halfhearted focus in current reality.
Courtesy of: www.investorwords.com
Beta: A quantitative measure of the volatility of a given stock, mutual fund, or portfolio, relative to the overall market, usually the S&P 500. Specifically, the performance the stock, fund or portfolio has experienced in the last 5 years relative to the S&P moving 1% up or down. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.
SafeMoneyMetrics® could apply the Beta concept. The RVR on the entire data sample (ALL) and it’s movement replaced the S&P500 and the RVR of an advisor or allocation would replace movement of the individual stock. Changes in the RVR ALL relative to changes in the RVR on time frames would be evaluated.
Increased Risk Potential and Traditional Benchmarks
The futures industry compiles monthly performance data of CTA’s and disseminates indexes. These Indexes are publicized as valid benchmarks for comparing individual CTA performance. Print and electronic media and both the traditional investment and futures industry perpetuate this “illusion of truth.” The indexes are probably useful for showing composite or mass trends in industry performance – we perceive that they should NOT be used to “JUDGE” the fate of any investment during a specific time frame, or be used as benchmarks for evaluating the trading skills of any trader. Performance of a good trader has NO relevance to an index. I perceive that the indexes can be superfluous and misleading because there seems to be no content relevance within the index or when used in comparison with any single investment or advisor. Account sizes, capital at risk, markets, time frames traded, and a myriad of other factors are not considered in how traditional rate of returns are calculated. When the performance of a few hundred CTA’s are compiled into an index, it appears to me that we have an index that can cause colossal confusion on a massive scale.
You Too - Can Love Time Frames!
The markets are volatile – and will probably get worse. Whether evaluating only managed futures and options or traditional money managers for integration into a balanced portfolio – we perceive that evaluating monthly performance over every 1,3,6,9,12,18,24,and 36 month time frame moving forward has more value than simply using one number representing an annual return. The exact strategy can also be applied to evaluating composite daily performance and every single trade. Nothing changes except the data source.
Remember Weakness!
The supreme weakness of SafeMoneyMetrics® is revealed when applied to monthly or compiled data. This is because all capital was not at risk, nor are returns produced during the same time frame. SafeMoneyMetrics® shines when applied to each trade using either live data for intra-day analysis or equity runs to evaluate the previous day’s activity! Daily results can “flow” into a composite performance analysis for each client account and are then compared to the “internal benchmark” which is created from composite monthly data provided by each advisor. For detail please see Client Risk Management, the PDF demo report.
The 51% Rule as a Benchmark
This is repeated from an earlier article. Content is important within the context of this article!
THE real benchmark that matters is something my very fundamental father taught me. “I only have to be right 51% of the time,” were his words. So as daily trade data builds it flows into pivot tables that consistently analyze a 51% rule – To accept any advisor and maintain a long-term relationship ask for and monitor the following over any 12 month time frame.
- 51% of all markets traded have to be profitable.
- 51% of all trades within each market have to be profitable.
- Profits have to exceed losses by at least 51% for each market traded.
- 51% of the initial margin required for each market is the maximum capital at risk on each trade.
- 51% of all markets traded at any time need to be profitable.
- Profits have to exceed losses of the composite portfolio by at least 51% at any one time.
Acceptable Variables: The above scenario maintains optimum balance and stability. Profitable departures from the optimum, offered by the marketplace may include 35% profitable markets, 45% profitable trades and profits exceeding losses by 65%. Many other combinations are also highly probable. To accommodate what the marketplace offers, without compromising your standards ask that if any one or more of the six variables is under 51% that another or others be over 51% by three times the difference.
For example: If a strategy has 45% profitable trades rather than 51%. Require that the profit to loss ratio on each trade be 69%, three times the difference between 45% and 51%.
WHY? Balance - although a strategy may be profitable, it may indicate excessive capital wasted to achieve profits, relative to an alternative. Also because of imbalance within the inter-dynamics of any strategy may lurk unwanted potential liability. WHY? Nature always seeks optimum balance. When any one element is out of balance nature will release or express the energy to rebalance. In managed futures/options that aspect of Universal Intelligence or release of energy will manifest as capital loss.
SafeMoneyMetrics® Secondary Benchmarks
SafeMoneyMetrics® Benchmarks (SMB) can also be created for each ratio, however rather than the realized ratio being divided by a standard deviation of the volatility ratio each ratio has its own average and standard deviation. When applied to time frames, or weighted moving averages relative to the initial decision for hiring the advisor, benchmarks reveal early warning signals for any possible discontinuance of effective trading relative to current market conditions.
For all Ratios a Standard Deviation around the average monthly ratio is created (gray cells). Also apply the standard Deviation to time frames for each ratio. This establishes a benchmark for how composite advisor performance was during most market conditions in the past. As time passes new monthly data is integrated into the “benchmark analysis.”
60-40 ALL |
RR |
VR |
NET |
FLR |
Average |
8.4% |
0.4% |
8.8% |
6.0% |
Maximum |
127.8% |
13.7% |
127.8% |
84.1% |
Minimum |
-52.3% |
-4.7% |
-52.3% |
-23.5% |
St.Dev |
26.62% |
2.70% |
26.92% |
17.97% |
RR – Realized Ratio: measures realized trading profits relative to capital at risk.
VR – Volatility Ratio: measures unrealized trading profits relative to capital at risk. Above and below is the 60-40 allocation data table summary and graph of all data points.
A constant relationship between the RR and VR is monitored because it quantifies how the advisor translates unrealized into realized trading profits – ITS GREAT when applied to time frames and daily trade data because risk management is tight in current reality! When applied to live data its even better! (see #Article 31 SafeMoneyMetrics® for Advisor Selection and Portfolio Monitoring.)
The realized to volatility relationship evaluates an investment's ability to translate open trade equity into realized profits. Optimal profitability and risk management is revealed when the realized ratio (realized profit or loss) is high & the volatility ratio (unrealized profit or loss) is low, or a wide positive difference is between them. When the realized ratio moves lower, & volatility moves up, risk is increasing. Remember short term time needs to be constructively integrated into a longer term risk management structure.
Net and Funding Level Relationships
To conclude this article we demonstrate how important the NR/FLR relationship is. For detail, take time with the analysis PDF demo report at www.safemoneymetrics.com
NR – Net Ratio: Monitors the composite realized and unrealized return on capital at risk and:
FLR – Funding Level Ratio: Monitors the composite realized and unrealized return on actual cash or leveraged account size.
The chart below represents a relationship between the NR and FLR. You can also graph data for different time frames. Sometimes the difference between all data and a specific time frame can be a valuable allocation tool.
A prudent allocation would have a large GAP between the Net and Funding Level Ratio, with the Net well above the Funding Level. That gap communicates that a large cushion of capital is available in the account AT its’ minimum funding level and degree of leverage being used under current market conditions. When the NR falls below the FLR it indicates that leverage being used is too high under current market conditions and constructive action should be taken.