“K2’s philosophy is to only worry about the downside. Returns will take care of themselves,” explains Ritchey.
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.”
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.”
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.”