Q. Although the contemporary art world just had one of its best weeks of sales ever, we’re not actually talking about art as an asset class here….
A. No. Today we’re talking Franco Modigliani, who won the Nobel prize in 1985. He was a very remarkable person, and one of the things he worked on was a more useful way of talking about one of our favorite subjects on Money Moves, risk adjusted returns. So, Modigliani Risk Adjusted Performance is essentially a more useful way of talking about the Sharpe ratio.
Q. Before we get to the improvement, remind us about Sharpe Ratios.
A. Risk adjusted returns are important of course: if one manager makes just a bit more than another, but took hugely greater risks to generate them, you’d probably prefer to be with manager #2. And so the Sharpe ratio tells you how much risk a manager took to generate a certain level of returns; it measures return for unit of risk. Now, remember, this is all MPT based stuff, so the way you figure out how much risk was taken is to look at the volatility of the returns. Risk and volatility are the same thing in that world.
Q. Right, so Sharpe is essentially a manager’s performance, divided by the volatility of his returns. And that gives us a ratio, where 1 is good, 2 is better, etc.
A. Correct. But the key thing you just said is also a bit of a problem: it’s an abstract ratio. So although someone might know that, say, a Sharpe of 1 is better than a Sharpe of .5, what exactly does that mean? It’s even tougher to compare a positive Sharpe to a negative Sharpe.
Q. Alright, how does Modigliani Risk-Adjusted Performance work, then?
A. It translates the Sharpe into units of percent return. So it’s very easy to compare 5% to 4.5%: one of the managers actually generated an additional 50 basis points of risk adjusted return.
Q. I see. And that information will be in the marketing materials?
A. Yes, sometimes it’s called M squared, because Modigliani co-created it with his granddaughter, Leah. Or even RAP: risk adjusted performance. But they’re all the same thing, Sharpe expressed in units of percent return.