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## The Omega Ratio – A Better Investment Performance Benchmark

Investors often use ratios such as the Sharpe Ratio or the Sortino Ratio to rank mutual funds, ETFs, and trackers. However, these conventional performance indicators have several flaws and are often very misleading. The Omega Ratio addresses these shortcomings and offers a more sophisticated approach to investing.

The Sharpe Ratio originated in the 1960s and is also known as the ratio of reward to risk. The effective return of a stock divided by its standard deviation, and the first advantage is that it provides a lot in the stock’s portfolio. Standard deviation is used by the Sharpe Ratio as a proxy for risk. But this is misleading for several important reasons.

First, standard deviation assumes that investment returns are normally distributed. In other words, the return has a typical bell shape. For many investment vehicles, this does not have to be the case. Hedge funds and other investments often exhibit skew and kurtosis in their returns. Skew and kurtosis are mathematical terms that refer to a distribution that is wider (or narrower) or longer (or shorter) than is typical of a normal distribution.

Second, most investors think of risk as the probability of loss – in other words the size of the left side of the distribution. This is not what the standard deviation represents, which simply indicates the investment returns spread around the mean. By discarding information from the distribution of returns, the standard deviation does not accurately represent the probability of excess loss.

Third, the standard deviation penalizes variation above the mean and variation below the mean equally. However, most investors are not just concerned about below-average volatility, they encourage above-average volatility. This point deals in part with the Sortino Ratio, which is similar to the Sharpe Ratio but only penalizes low deviations.

Finally, historical averages are used to show expected returns. This is again misleading because the average gives equal weight to going back to the distant past and back to the past. The latter is a better indicator of future performance than the former.

The Omega Ratio was developed to address the inefficiencies of the Sharpe Ratio. The Omega ratio is defined as the area of the return distribution above a threshold divided by the area of the return distribution below a certain threshold. In other words, it is the high probability weight divided by the low probability weight (with the higher value greater than the lower value). This description accurately captures all the important information of the return distribution, and most importantly, it accurately describes the probability of excessive losses.

However, investments with a high Omega ratio are more volatile than investments with a high Sharpe Ratio.

The Sharpe Ratio and Omega Ratio can be easily calculated using tools such as spreadsheets or other math packages.

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