Q. Well lots of investors probably think they know what this means, given the volatility of the last few weeks, but this index is actually no joke…
A. I’m a big fan for two reasons: first, you gotta love the name. Second, it’s an extremely useful way of evaluating investment performance, especially for the many kinds of hedge funds that primarily seek to avoid big losses. Its probably a better yardstick, for example, than the Sharpe Ratio for evaluating risk-adjusted returns.
Q. OK, so, from previous buzzword segments, we know the Sharpe Ratio evaluates risk adjusted returns by comparing performance and volatility. What’s the big advantage of the Ulcer?
A. Instead of dividing performance by standard deviation, it divides performance by the size and duration of the fund’s drawdowns. And those drawdowns are what really give you ulcers. I think we have a chart that helps illustrate this…
Q. So this shows the performance of the S&P for the first decade of the century on a month by month basis.
A. Right. The blue is the actual peformance; the pink rearranges the moths so all the worst ones come first; the yellow shuffles them to minimize drawdowns. They all wind up in the same place– but both the actual performance and the worst first are definitely ulcer inducing. More than that, if an investor had a big college tuition bill to pay in a down period, or didn’t have the “stomach” to stick it out, the damage would have been much more real than just heartburn.
Q. Well, that makes sense, but as a practical matter how different is it from the Sharpe and Sortino?
A. As compared to the Shapre, you don’t penalizing the manager for “upside” volatility– which, of course, nobody seems to mind. That’s a big deal. And as compared to the Sortino, the Ulcer is that it gives managers more credit for timing– not just how often they’re out of the market, ,but whether they’ve either out of the market, or very well hedged, at the right times.
Q. So, as you say, particularly useful for measuring strategies that are trying to minimize losses…