Letters to the Editor
To The Editors:
After reading the sidebar entitled Risk-Adjusted Returns [found in the article “What’s Up? AAII’s Shadow Stock Portfolio,” January 2004 AAII Journal and in the Model Portfolios area], I’m a bit confused by James Cloonan’s approach to the question: What does risk matter?
To date, I’ve referred to “risk-adjusted return” as the “Sharpe ratio.” By expressing an asset’s return per unit of risk, it provides an objective indication of an asset’s risk-adjusted performance. In short, it facilitates the side-by-side comparison of dissimilar assets by considering risk as well as return.
I’m not certain the Model Portfolio discussion of risk-adjusted return reflects the simplicity offered by the Sharpe ratio. The examples cited would tend to be found in discussions of portfolio construction where the effect of debt and riskless assets is addressed within the context of how those variables affect portfolio return and variance. The original question is right on target. I don’t think the paragraphs that follow adequately address it.
James Cloonan Responds:
Thank you for your comments about risk-adjusted return. I certainly agree that the Sharpe ratio will show the relative return/risk of different assets and is effective in choosing between them. It only orders them, however, and does not indicate the amount of extra return that can come from risk reduction based on an individual’s risk tolerance. I feel this is important and emphasizes the interchangeability of risk and return. The rank order of Sharpe ratios and our risk-adjusted returns will be the same.
To The Editors:
The April 2004 AAII Journal article discussing the intricacies of the new tax rules for qualifying dividends made me worried [“Good News/Bad News: For Dividends, New Tax Law Means Lower Rates But More Headaches,” by Ellen J. Boling and Mark H. Gaudet]. I have a margin account with TD Waterhouse and it contains several dividend-paying stocks. I called the broker and discovered there is yet another way to avoid receiving payments in lieu of dividends for stocks in a margin account. The representative I spoke to said that the brokerage firm may loan out stocks only when an account has a margin or loan balance. I have had this account for about 10 years and have never traded on margin. That is, I have never borrowed funds to make a trade. I maintain a margin account to be eligible to trade options at the highest level. The representative also said that monthly statements will contain a “payment in lieu of dividends” section. In this way I can track such payments throughout the year. I do not know if this is only a TD Waterhouse rule, or if it is followed by other brokerage firms.
To The Editors:
Having been introduced to hedge funds late in my investment life, likely because of the frequent and persistent negative information issued against them, I wish to take exception to the Briefly Noted article, “Hot Hedge Funds Turn Lukewarm in Hot Markets,” in your April 2004 AAII Journal.
The article states: “hedge funds may have fared well during the last bear market, but they are far from a sure bet for continued gains now that the market has turned around.” If you compare the 10 years of results posted in the article, the hedge fund index best demonstrates “continued gains”—it has had only one negative year and that by only –3.51% compared to three down years for the S&P 500.
The article also states “they engage in aggressive hedging strategies to limit the downside when markets turn sour.” To me this says that hedging your position is riskier than holding an unhedged position or one should never consider limiting one’s losses. Think about that.
The final statement suggests that Hennessee’s hedge fund index results “overstate fund performance because of survivorship bias—it does not reflect the fact that many partnerships go out of business... .” While I’m sure there are many hedge funds that do fold as a result of losses, this ignores the fact that most partnerships are created with a limited life and are discontinued with positive payoffs to their participants. Not including their results may actually be adversely impacting the Hennessee results.