The impact of downside risk on risk-adjusted performance of mutual funds in the Euronext markets
AbstractMany performance measures, such as the classic Sharpe ratio have difficulty in evaluating the performance of mutual funds with skewed return distributions. Common causes for skewness are the use of options in the portfolio or superior market timing skills of the portfolio manager. In this article we examine to what extent downside risk and the upside potential ratio can be used to evaluate skewed return distributions. In order to accomplish this goal, we first show the relation between the risk preferences of the investor and the risk- adjusted performance measure. We conclude that it is difficult to interpret differences in the outcomes of risk-adjusted performance measures exclusively as differences in forecasting skills of portfolio managers. We illustrate this with an example of a simulation study of a protective put strategy. We show that the Sharpe ratio leads to incorrect conclusions in the case of protective put strategies. On the other hand, the upside potential ratio leads to correct conclusions. Finally, we apply downside risk and the upside potential ratio in the process of selecting a mutual fund from a sample of mutual funds in the Euronext stock markets. The rankings appear similar, which can be attributed to the absence of significant skewness in the sample. However, find that the remaining differences can be quite significant for individual fund managers, and that these differences can be attributed to skewness. Therefore, we prefer to use the UPR as an alternative to the Sharpe ratio, as it gives a more adequate evaluation of the use of options and forecasting skills.
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Bibliographic InfoPaper provided by EconWPA in its series Finance with number 0407016.
Length: 14 pages
Date of creation: 21 Jul 2004
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Note: Type of Document - pdf; pages: 14
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Downside risk; mutual funds; performance measurement; risk preference; asymmetric return distributions;
Find related papers by JEL classification:
- G - Financial Economics
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-07-26 (All new papers)
- NEP-CFN-2004-07-26 (Corporate Finance)
- NEP-CMP-2004-07-26 (Computational Economics)
- NEP-FIN-2004-07-26 (Finance)
- NEP-FMK-2004-07-26 (Financial Markets)
- NEP-RMG-2004-07-26 (Risk Management)
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- Karyl Leggio & Donald Lien, 2003. "An empirical examination of the effectiveness of dollar-cost averaging using downside risk performance measures," Journal of Economics and Finance, Springer, vol. 27(2), pages 211-223, June.
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