This week we sold out of FXI and entered THD. Our current three positions are THD, TMF, and IFN. The stops and targets model was stopped out of TMF and will remain in cash until the model generates a fresh entry.
The MSCI World Index closed the week down -1.95%. The ETF Country Plus model ended the week up +0.18%. The ETF Country Plus Strategy is up +16.71% year-to-date compared to its benchmark, the MSCI World Index, which is now up +2.57% year-to-date.
This Week’s Strategy Lesson: Measuring Your Model (Part 4 of 4)
For this final installment in this series we are going to compare two different measures of risk: the Sharpe ratio and the Sortino Ratio.
Standard Deviation vs Downside Volatility
Last week we discussed standard deviation as a measure of volatility. While it cannot be used as a precise measure of risk (because markets are only approximately normally distributed and because the future returns and volatility can vary widely from the past), it can still be used to give us useful information about the risk characteristics of a stock, fund, or trading model.
If you have taken a statistics class, you probably have heard your professor say more than once: “Standard deviation is the square root of the variance.” I’m sure that really clarifies it for everyone. We don’t need to know the details of how it’s calculated for this piece of analysis, however here is the formula for those who might be interested.
The calculation is basically finding the average variation in a set of numbers and then using that average variation to determine the probabilities of certain different numbers occurring. If we have a very tight average variance than we would expect lower degree of variation in future datasets, whereas a wide variation in our sample would lead us to expect a continued wide variation in the future.
In the standard volatility calculation, we take all the monthly returns. However, in the “downside volatility” calculation, we only take the monthly returns of those months that had a negative return (or below some threshold). The main idea behind this added nuance is that what investors really care about is the volatility when the instrument moves against you, not the volatility when it moves in your favor.
Some strategies or funds are equally volatile on drawdowns as they are on positive gains. For many strategies, though, this is not the case. And we have all heard the old adage that markets move down a lot faster than they move up.
Comparing the standard deviation and downside volatility for both the SPY and the ETF Complete Portfolio, we can see that the ETF Complete Portfolio had a smaller percentage of its volatility from negative returns than the SPY by a fair amount.
Practically what this means is that if you are principally worried about volatility on the downside (and don’t care about volatility when something is moving in your favor), that the Sortino ratio is going to be a better measure of risk for you than the Sharpe ratio.
Sortino Ratio
The Sortino ratio was created as an alternative way to measure risk adjusted returns. Unlike the Sharpe ratio which uses standard deviation (volatility of all returns), the Sortino ratio only uses the downside volatility for its measure of volatility. As was mentioned earlier there are many times where the Sharpe and Sortino will be very similar.
In a perfect normal distribution, they will be identical. This is because the returns are not necessarily skewed in either direction and the standard deviations are equal for positive and negative returns:
However, if the distribution of returns is skewed in one direction or another and particularly if the standard deviations vary, the Sortino ratio gives us more information about the risk characteristics than just the Sharpe ratio alone:
We have just such a skew in the ETF Complete Portfolio where the downside returns have less volatility than the upside returns. This means that we should expect a more favorable Sortino score.
While it becomes difficult to make direct comparisons between the Sharpe scores and the Sortino scores, it should generally be noted that both give us useful information and if there is a wide variance between them that the Sortino score becomes increasingly relevant. But once again, it’s a relative score so it is primarily used to compare performance and risk between funds and it must be used in coordination with the other metrics we have looked at.
We hope that this series has provided useful information for evaluating the risk profiles of not only our ETF models, but any trading system or fund. Many of these metrics are industry standard and can be used to make better more informed investing decisions.
The Current Condition of the Model
For the country model, we are in THD, IFN, and TMF. THD is a new position. TMF was stopped out in the stop & targets model but it remains a position in the basic model and is currently the number one ranked ETF in the Country ETF list.
Stay tuned to daily updates for any position changes.
Here is a summary of the weekly performance of all the ETFs that the strategy monitors:
Best wishes for your trading,
James Kimball
Trader & Analyst
MarketGauge