This common measurement tool for assessing risk and return is based on the belief that broad risk is measured by volatility. But volatility is not the same as loss, and thus not always an accurate way to represent risk. The Sharpe Ratio also assumes return normality, fails to capture the frequency and depth of declines, and does not account for illiquidity—pitfalls that are most apparent when assessing hedge funds.
Investment capture is an approach that incorporates both risk and reward into the same metric by setting up an ideal target range for returns. It is a useful strategy in building an entire portfolio, or assessing an individual manager or asset class. Incorporating the potential for loss, while setting targets for gains, better prepares the investor for what to expect.
Drawdown measures the peak-to-trough decline in an investment and the time period between each peak. Drawdown-based metrics, such as the Pain Index, Calmar Ratio, Omega Ratio and Conditional Value at Risk (CVaR), more accurately capture the investor experience by assessing risk in terms of actual loss and recovery from that loss, as opposed to volatility.
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