Ratio Shopping: A Deep Dive into Capital Decimation Partners
“Caveat emptor…” Let the buyer be ware!
Manager due diligence is part art and part science; the hard part is not to be fooled by science! Financial ratios, e.g., Sharpe, tend to be backed by the name of someone more famous than the author of this work and backed by pages upon pages of academic work. The seal of approval by the investment community comes when that ratio becomes part of the syllabus in some professor’s lecture and/or merits a chapter in some thick textbook on investing. Alas, the only certainty in investments is that there is no certainty. Buried in textbooks and journal articles are usually explicit assumptions, such as normality, or, worse yet implicit assumptions.
What is a humble advisor to do?
It goes without saying that there is no answer to that question, but the answer to the question, what to do, deserves some discussion. A fulsome approach to due diligence requires that one think beyond one’s academic and classical training. Just as any investor is more than his/her height or I.Q., so too is an investment more than just a few numbers. This is laid out transparently by Andy Lo and his fictional fund, Capital Decimation Partners1.
The fund employs a short-put-option strategy consisting of selling out the money S&P 500 put options with strikes approximately 7% OTM and with maturities less than or equal to 3 months from January 1992 to December 1999. The fund is designed to blow up after the Tech bubble. The enviable statistics are below.
These statistics on their face look extremely promising. If one were simply “ratio shopping”, then buyer’s remorse would set in during the crash of 2000. These statistics can help, but this case illustrates the perfect example of why they are not foolproof and why fund evaluation is part art and part science. Surely there are other examples, but this one usually gets the point across.
What is a humble advisor to do (again)?
It is hard to say what to do in each and every circumstance, but, given the availability and accessibility of so many risk, performance attribution, and financial ratio calculators, I would say to do it all. Getting a handle on investment risk involves a “mosaic of metrics”. Then, it might be useful to ask yourself 3 questions:
Do I understand why this person has made money?
Do I understand why this person will continue to make money?
Do I trust this person?
Ratio calculation can be a good introduction to fund performance, but it may not be enough to invest. Everyone wants to avoid buyer’s remorse, and that involves more than superficial work.