The Factsheet Tricks, 7 of 10
The too-smooth line
Hard-to-value assets can report returns smoother than reality, so risk looks low.
What it is
When an investment holds things that don't trade every day, their value is often estimated. Estimates move slowly, so the reported returns look calmer than the real ups and downs. Risk looks lower and risk-adjusted scores look higher.
Why it works
- When assets are hard to value, reported returns can look smoother than reality. One study found risk-adjusted scores overstated by up to 65%.E18
Illustration, not a real fund
Smooth and steady growth
Sharpe ratio of 2.38
Returns look smoothed: each month tends to repeat the last (autocorrelation 0.54). Corrected for that, the score is 1.57.
Illustrative smoothed series. Figures computed by the openfactsheet library.
How to spot it
- Be wary of a growth line with almost no dips.
- Ask how the holdings are valued, and how often.
What OpenFactsheet does
Checks whether each month tends to repeat the last, flags likely smoothing, and reports a risk-adjusted score corrected for it (Lo, 2002).
The full example
The same illustrative fund, as a pitch would show it and as the full record does.
What the pitch shows
Investor presentation- 8.78% a year
- Smooth and steady growth
- Sharpe ratio of 2.38
Growth over 8 years, as a pitch would chart it.
What a second opinion adds
Same fund, full record- Biggest historical drop
- -8.85%, from its March 2020 high to June 2020.
- Time to get back to the previous high
- 17 months, back at its March 2020 level in August 2021.
- Worth a closer look
- The returns look smoothed: each month tends to repeat the one before. That can make an investment look steadier than it really is, so its risk figures are probably understated. 4 months were also extreme compared with the rest of the record.
- Allowing for the smoothing, the headline score the pitch quotes falls from 2.38 to 1.57.
What does this mean?
The Sharpe ratio is a popular score: return earned for each unit of ups and downs. When returns are smoothed, part of the ups and downs is hidden, so the score looks better than it should.
OpenFactsheet also reports a version adjusted for this (Lo, 2002). The smoothing shows up as a month-to-month correlation of 0.54 (values near zero are typical for investments priced daily by a market). Both versions use a 0% risk-free rate.
Illustrative example, not a real fund. Built from synthetic returns; every figure is computed by the openfactsheet library from its 96 monthly returns.
Sources
- E18 Getmansky, M., Lo, A.W. & Makarov, I. (2004). "An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns." Journal of Financial Economics 74(3), 529–609. Lo, A.W. (2002). "The Statistics of Sharpe Ratios." Financial Analysts Journal 58(4), 36–52.
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