We judge performance (excess/shortfall returns relative to strategy benchmarks) on a risk adjusted as opposed to absolute basis – in industry parlance, we aim to maximize Sharpe and Information Ratios.
For example, if an equity manager generates a 12% return during a period when the S&P 500 generates 10%, we look at the risk (measured by standard deviation) the manager deployed relative to risk experienced in the S&P 500 over the same time period. If the 200-basis point in excess return was generated deploying and incremental 800-basis points in risk, we may conclude the manager underperformed. Why? His upside capture in is poor, for every 1% of incremental risk the manager is adding 0.25% of incremental return. This may indicate that the manager is taking too much uncompensated risk, which eventually generates excessive “tail risk” (see graph overleaf) in the strategy.