In the wake of the recent credit crisis there has been a lot of discussion around the idea of tail risk, i.e. rare, but extreme and traumatic events. We believe one of the best ways to analyze tail risk is to use the Omega ratio developed by Con Keating and William Shadwick. Simply put, Omega measures the count and the scale of observations above a minimum accepted return (MAR) and contrasts them with the count and scale of observations below the MAR.
Zephyr first incorporated the Omega ratio in to StyleADVISOR in 2006, but since then we’ve built on the idea a lot to make the concept easy to use and understandable. Some of those enhancements to our offerings on Omega include:
• The S-shaped cumulative distribution of returns graph, which is instrumental in understanding the idea of Omega
• A separate graph that shows how the Omega ratio changes as the minimum accepted return (MAR) changes
• The ability to distinguish the “good” from “bad” portions of Omega by breaking out the overall ratio in to the Upside Omega and Downside Omega
• A more academically-inclined discussion of Omega penned by Dr. Thomas Becker of Zephyr Associates
• A more practical discussion of Omega, including information on uses and typical Omega values observed for different asset classes
When Keating and Shadwick unveiled the idea of Omega, they called it a “universal performance metric”. They did so because Omega captures all four moments of a distribution, namely the return, standard deviation, skewness, and kurtosis. When displayed on the S-graph, the analyst gets a good feel for the tail risk of an investment. Finally, Omega is very useful when looking at both absolute return strategies that are not benchmark driven as well as total portfolios with a target level of return.
We hope you find this information useful and interesting and welcome any comments or questions.
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