Alternative Intelligence Quotient

The Performance of the SFA

Score vs Traditional Risk-adjusted
Performance Measures
Peter Urbani, Infiniti Capital

Peter Urbani is Chief Investment Officer of Infiniti Capital, a Hong-Kong-based hedge fund of funds group.

Issue 33, December 2009

Ever since the seminal work on Portfolio Theory by Harry Markowitz (1959) and the subsequent work of William
Sharpe, the measurement of portfolio returns has been inextricably linked to the level of risk associated with
achieving those returns.

This has led to the introduction of a number of risk-adjusted performance measures (RAPMs), most famously
the reward-to-variability, or Sharpe Ratio.

Typically calculated as the portfolio returns in excess of those of the risk-free rate over the standard deviation
of portfolio returns, the Sharpe Ratio embeds the concept of the variance, standard deviation squared, or
volatility as the appropriate measure of ‘risk’ to use.

Over time, practitioners and academics alike have realised that this poses a number of problems for the
accurate measurement of ‘risk’. In fact, the use of variance was largely an act of convenience to simplify the
math in the days before computers. Markowitz himself has said that for some investors semi-variance might
be a more appropriate measure to use.

The reason for this is simply that variance, or standard deviation as is more commonly used (the square root
of the variance), is not a measure of ‘risk’ at all, but rather a measure of uncertainty. Standard deviation
suffers from a number of well known deficiencies, most particularly the fact that it does not differentiate
between good (upside) ‘risk’ and bad (downside) ‘risk’. Moreover, it is a symmetric measure that assumes
both upside- and downside-variance are the same.

In recognition of these deficiencies, a number of other RAPMs have been developed to better address these
issues. Probably the best known of these is the Sortino Ratio which replaces the standard deviation with the
downside deviation or second lower partial moment (LPM2) as the denominator in the Sharpe Ratio.

Still others include the modified Sharpe Ratio where the denominator of risk is represented by the Cornish
Fisher expanded or ‘modified’ Value at Risk (VaR).

More recently, Shadwick and Keating pioneered the use of the Omega Functio,n sometimes also used as
the Omega Ratio. In this formula, the area under the probability curve in excess of some threshold return is
taken over the area under the curve of the downside part of the distribution. This can be calculated in either
a discrete form using empirical data, or a continuous form by fitting a distribution.

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 From a practitioner’s perspective, what we care
most about is how well these measures predict
the relative ranking from one period to the next
and whether or not using one particular method
produces superior returns to another. Although
these RAPMs are typically used for calculating the
relative ranking of funds they can also be, and
often are, used as the objective function in direct
portfolio optimisations. For instance, maximising
the value of your portfolio’s Sharpe Ratio is the
same as minimising its variance and gives the same
set of weights as the classical Markowitz mean
variance optimisation formulation. Minimising your
‘normal’ VaR will give the same solution. However, as
mentioned previously, measures based on standard
deviation such as Sharpe and the normal VaR
calculation do not consider the asymmetry of returns.
The study referenced below, compares the out-
of-sample performance of a portfolio built using
the SFA score as its objective function versus the
performance of portfolios built from the same data
set using the Sharpe, Sortino and Omega measures.
For reference we also include a naive benchmark
made up of an equally weighted continuously
rebalanced portfolio of all of the 36 underlying
hedge funds in the selection universe. The portfolios
are re-optimised to the objective function and
rebalanced on a quarterly basis.
The results of the study suggest that the SFA score is
capable of generating annualised rates of returns
(CAGR) of around 15% versus those of around
11.5% for the Sharpe Ratio, 13% for the Omega
Ratio, and just 10% for the Sortino Ratio.

In this article, we examine the performance of a
new risk-adjusted performance measure called
the Single Fund Analysis (SFA) score, developed by
Infiniti Capital. This measure is a weighted average
of a number of underlying statistics that has also
been standardised to a reference data set making
it both a relative and conditional measure. The SFA
score can further be decomposed into risk, return
and persistence sub-scores.
More importantly, although the Sharpe Ratio of
the resultant time series remains better for both
the Sharpe and Omega portfolios, the ratio of the
annualised return to the absolute drawdown over
the period, which is arguably a better measure of
realised risk to return, remains highest for the SFA
score portfolio.

Equally-
Key statistics SFA Total Omega Sharpe Sortino
weighted fund
CAGR 15.09% 12.93% 11.44% 10.07% 10.36%
Annual return 14.34% 12.35% 10.97% 9.80% 10.08%
Annual SD 6.50% 5.07% 4.35% 5.72% 6.12%
Skew 0.78 -0.13 0.4 -0.21 -0.67
Kurtosis 0.00 -0.39 0.67 0.29 0.52
Normal VaR 95% -1.89% -1.38% -1.15% -1.90% -2.07%
Infiniti VaR 95% -1.25% -1.43% -1.15% -1.99% -2.30%
Sharpe Ratio 1.77 1.86 1.85 1.20 1.17
CAGR/ABS (Drawdown) 3.41 2.39 3.27 1.05 0.93
Max drawdown -4.43% -5.41% -3.50% -9.56% -11.10%

Johnson Mixture of Modified Log normal

Best-fit distribution Gumbel (Max)
(Lognormal) normals normal (max)

Portfolio’s relationship to benchmark (equally-weighted fund )

Correlation 0.79 0.87 0.78 0.91 1.00
Beta 0.84 0.72 0.56 0.85
Alpha (monthly) 0.49% 0.42% 0.45% 0.10%
Information Ratio 1.03 0.76 0.23 -0.11

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The reason for the superior performance of the SFA
scores is due to it not being a simple point estimate,
but being calibrated relative to a reference
data set of other hedge funds. This improves the
predictive power of the method because it responds
dynamically to market conditions. In order to ensure
the availability of data for the SFA reference scores,
the portfolios are also optimised with a one-month
data lag. This means that January SFA scores which
only become available in February are used to
obtain the March opening portfolio weights.
Unlike traditional performance measures, the
SFA score is both conditional on the time period
being used and relative to a large reference data
set of other hedge funds. Where other methods
typically standardise everything back to a normal
or Gaussian distribution, the IAS uses the best
fitting distributions throughout. This has the effect
of calibrating the range of scores more closely to
real-world data.
Of course, the method is not perfect. The SFA
scores will not provide the best returns over each
and every single time period, however, over any
meaningful length of time they will tend to out-
perform.
Alternative Intelligence Quotient
We were somewhat surprised by the poor
performance of the Sortino Ratio portfolio relative
to that of the Sharpe Ratio portfolio. We believe
this may have been due to the fact that the quality
of the 36 underlying hedge funds used was very
good. This enabled the computer to select portfolio
weights that gave a portfolio with zero downside
deviation in the in-sample optimisation periods.
The low variance of these portfolios did not persist
out-of-sample in the subsequent periods causing this
portfolio to underperform.
This is a classical problem of over-fitting your
data which results in there being little relationship
between the in-sample period and the performance
in the next period. The Sharpe Ratio suffers from a
similar problem, but more because it is capturing
Issue 33, December 2009
only the linear effects of the portfolio whereas we
know there are significant non-linear effects present
in hedge funds.
The SFA score is able to capture some of these
non-linear artifacts because of the statistics used
in its calculation and the best-fitting non-normal
distributions it uses. These have the effect both of
improving the predictive power of the method and
ensuring the resultant pay-off is positively skewed,
or as close to positively skewed as possible. This
translates into more upside risk than downside risk.
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 Subsequent studies, where we have used less well-performing hedge fund indices, have confirmed our beliefs
and the intuitive expectation that the Sortino Ratio should out-perform the Sharpe Ratio.

The SFA score has been used by Infiniti to manage real portfolios over the past two years. All of the
calculations used to obtain these results, the dataset used, and a trial version of the software used, are freely
downloadable from www.infiniti-analytics.com for third parties to evaluate.

Peter Urbani
Infiniti Capital
peter.urbani@infiniti-capital.com
Tel: 64 3 977 8811

References:

The Infiniti SFA score as a RAPM, Peter Urbani (2009), www.infiniti-analytics.com/kb/kb/article/

infinitisfascorearapm.

Portfolio Selection: Efficient Diversification of Investments, Harry Markowitz (1959), http://cowles.

econ.yale.edu/P/cm/m16/index.htm.

Sharpe Ratio, William Sharpe, http://en.wikipedia.org/wiki/Sharpe_ratio.

Sortino Ratio, Frank Sortino, http://en.wikipedia.org/wiki/Sortino_ratio.

Omega Ratio — A Universal Performance Measure, Keating and Shadwick (2002), www.performance-
measurement.org/KeatingShadwick2002a.pdf.

Modified Sharpe Ratio, www.andreassteiner.net/performanceanalysis/?External_Performance_

Analysis:Risk-Adjusted_Performance_Measures:Modified_Sharpe_Ratio.

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