Practical Risk-Adjusted Performance Measurement. Carl R. Bacon
I wanted to document, with appropriate referencing, as many discrete ex-post risk measures as possible in a structured format, filling gaps, encouraging consistency, suggesting new measures and highlighting possible areas of confusion or misrepresentation. In truth many of these measures are rarely used in practice, often for good reason.
This book will not recommend any particular risk measure, although it is difficult to disguise my preferences and prejudices. Risk, like beauty, is very much in the eye of the beholder and different risk measures will suit different investment strategies or asset owner concerns at different times. This book should provide enough information and insight for the reader to determine their own preferences.
In terms of structure Chapter 1 is naturally an introduction to the subject of risk in the context of asset management firms. In Chapter 2 the foundations are laid introducing the descriptive statistics that will be used in later chapters. The following chapters are structured according to the type of risk measure being considered: simple performance appraisal measures in Chapter 3; regression measures in Chapter 4; drawdown in Chapter 5; partial moments in Chapter 6; a new Chapter 7 based on prospect theory; extreme risk in Chapter 8; risk measures for fixed income instruments in Chapter 9; a new Chapter 10 including miscellaneous risk measures that are difficult to characterise; and risk-adjusted returns in Chapter 11.
Chapters 12–16 are entirely new chapters for this edition. Chapter 12 was really inspired by the background research and writing of the first edition. I wanted to classify all the ex-post risk measures and describe how they are linked; my thoughts came together too late to include the best presentation of this linkage in the first edition, which is, of course, a periodic table of risk measures. Chapter 13 discusses the use of risk-adjusted performance measures in the context of performance fees. Chapter 14 discusses dashboard design in the context of risk measures, Chapter 15 looks at the important subject of how appraisal measures should be used in the context of manager selection and Chapter 16 introduces the four dimensions of performance and makes the call for ex-ante risk standards.
In the penultimate Chapter 17 there is a discussion about which risk measures to use and finally Chapter 18 reviews their application in terms of risk control.
The objective of this edition remains to provide a complete list of ex-post risk measures used by asset managers. Although some have little merit, I've avoided censoring measures I dislike. If a risk measure is not included, maybe I don't fully understand it with enough confidence to write about it, or in a few rare cases I've determined that it literally has no merit.
Note
1 1 The misuse of mathematics in order to mislead; see Paul Romer (2015) Mathiness in the Theory of Economic Growth. American Economic Review 105, 89–93.
Acknowledgements
My thanks are owed to many who have contributed to this book, both directly and indirectly – working colleagues over many years, attendees at my various training courses and workshops which I hope will continue, attentive readers of my previous books who have spotted a number of errors and indeed made many good suggestions, numerous fellow GIPS® committee members who have been so insightful and of course the many authors who have laid the foundations of this subject.
I'm particularly thankful to the diligent reviewers of this book, in particular Damian Handzy, Neil Riddles, Paul Giles and Joe Kavanagh for their numerous detailed comments and suggestions; this book is much better for their contribution. Of course, all errors and omissions are my own.
Carl R. Bacon CIPM
Deeping St James
August 2021
About the Companion Website
This book is accompanied by a companion website: www.wiley.com\go\bacon\riskadjustedperformance2e
The website includes:
Excel spreadsheet with supporting data and underlying calculations for all exhibits
The Periodic Table of Risk Measures
CHAPTER 1 Introduction
“Money is like muck, not good except it be spread.”
Francis Bacon (1561–1626)
DEFINITION OF RISK
Risk means very different things to different audiences at different times; risk is truly in the eye of the beholder. In the context of asset management, the Oxford English Dictionary provides a surprisingly good definition of risk:
The potential impact of an event determined by combining the likelihood of the event occurring with the impact should it occur.
Risk is the combination of exposure and uncertainty. As Holton1 (2004) so eloquently points out it is not risky to jump out of an aircraft without a parachute because death is certain. Holton also points out that we can never operationally define risk; at best, we can operationally define our perception of risk.
Another common and effective, but broader definition of risk is exposure to uncertainty.
RISK TYPES
Within asset management firms there are many types of risk that should concern asset managers and senior management. For convenience I've chosen to classify risk into five main categories:
Compliance Risk
Operational Risk
Liquidity Risk
Counterparty Risk
Portfolio Risk
These