When constructing a portfolio, adding a low correlation, low Sharpe ratio strategy can have the same impact as adding a high Sharp ratio strategy. The low correlation strategy is a great diversifier.
The core argument presented in this paper –that SR is a misleading index of whom a fund should hire or fire– seems at odds with standard business practices. The SR Indifference Curve shows that even PMs with a negative individual SR should be hired if they contribute enough diversification. Why is that not the case? Because of a netting problem: A typical business agreement is that PMs are entitled to a percentage of their individual performance, not a percentage of the fund’s performance. Legal clauses may release the fund from having to pay a profitable PM if the overall fund has lost money, however that PM is unlikely to remain at the firm after a number of such events. This is a very unsatisfactory situation, for a number of reasons: First, funds are giving up the extra-performance predicted by the SR Indifference Curve. Second, funds are compelled to hire ‘star-PMs’, who may require a high portion of the performance fee. Third, funds are always under threat of losing to competitors their ‘star-PMs’, who may leave the firm with their trade secrets for a slightly better deal. In some firms, PMs’ turnover is extremely high, with an average tenure of only one or two years. Read more
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