With this ratio, the larger the number the better, and a comparison to peers is necessary to determine whether a number is “good” or “bad.”
K-Ratio Addresses a Standard Deviation Flaw
As an added benefit, the K-ratio addresses one of the long-standing complaints regarding the use of standard deviation as a risk measure: it does not and cannot take into account the timing of bad returns. If there are a dozen very bad monthly returns over the span of ten years, standard deviation cannot tell whether those bad months were randomly scattered throughout a decade or if they were all clustered in a small period of time. Anyone who remembers the dark days of late 2008/early 2009 can recall that some of the worst months in memory were tightly clustered within a few quarters.
The standard error of the mean and the K-ratio remedy this. A financial crisis pushes the investment from the idealized straight line, so you can clearly see where that cluster of bad months happened.
The Zephyr K-Ratio in Action: A Comparison
For the K-ratio to have meaning, it must be compared to other investments’ K-Ratios. Using the Defined Risk Strategy (DRS) as an example, we compare the K-Ratio for the DRS Select Composite to the S&P 500.
The DRS Select Composite looks strong when analyzed in terms of consistency of wealth creation in contrast to the S&P 500. First of all, the slope of the best-fit line is steeper than that of the S>&P 500, meaning the DRSSelect Composite does a better job of creating wealth.
Source: Zephyr StyleADVISOR, Swan Global Investments. All S&P 500 data based on historical performance of the S&P Total Return Index. All historical performance of the Swan. Select Composite is net of fees. Prior performance is not a guarantee of future results.
Secondly, and more importantly, the actual data line tends to hug the idealized best-fit line much more closely than the S&P 500 fits its ideal line. This is the consistency part of the equation.
A strong return metric divided by a smaller risk metric will certainly lead to better overall ratios. That is what we see with the K-ratio metric—the DRS winning on both the wealth creation and consistency fronts.
Defined Risk Strategy: Smooth & Consistent Wealth Creation
The DRS was devised with this goal in mind: to provide a nice, smooth, constant rate of wealth creation. The K-ratio illustrates how well the strategy was able to achieve that goal.