“K2’s philosophy is to only worry about the downside. Returns will take care of themselves,” explains Ritchey.
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The Sharpe ratio is not his favourite metric, to use an understatement. “It is incredibly inefficient, because it looks at the two-way standard deviation. So you’re getting penalised if you have huge upside volatility.”
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Ritchey believes VaR is a more efficient ratio, because it only focuses on downside volatility. “We spend a lot of time looking at the expected performance to VaR.”
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But there is a problem associated with VaR: it is a historically derived metric. Ritchey tries to overcome that by identifying the most likely stress event that’s going to happen, and running the expected performance of a fund relative to a stress test replicating this event. “This would be the worst-case VaR. If the manager passes the test, then you are probably ok including him.”
