The Omega Ratio as a Mutual Fund Performance Measure

Published: June 7, 2016 at 8:50 am

Last Updated on

The Omega ratio is an interesting performance evaluation metric that can be used for evaluating a mutual fund with its benchmark and also compare funds. In this post, I present a simple, non-technical description of the omega ratio along with some examples.

The Omega ratio has been part of the mutual Fund risk vs return analyzer since inception. I refer to it as interesting because it is superior to commonly used metrics like the Sharpe and Sortino ratios because it does not require returns (monthly/weekly/daily) returns to fall on a nice bell curve (the which they don’t!). The Omega ratio considers fat tails too.

Although the calculation is quite different, the idea behind the Omega ratio is similar to the downside and upside capture ratios, but at the same time a lot more flexible.

Note: I would like to introduce different risk-return metrics because I am a student of the subject. Please do not confuse my curiosity with investment advice. My aim to learn, create tools and share them here. What you choose to use or not use is up to you.

To understand what the Omega ratio is, it is important to recall what the downside and upside capture ratios refer to.

Downside capture ratio = Downside CAGR of fund/Downside CAGR of index

Downside CAGR of the fund (or index)  is the annualised return by counting only those months/weeks/days when the index return was negative (<0).

A low downside capture ratio implies the fund has lost less than its index when the index did poorly.

Similarly,

Upside capture ratio = Upside CAGR of fund/Upside CAGR of index

Upside CAGR of the fund (or index)  is the annualised return by counting only those months/weeks/days when the index return was positive (>0).

A large upside capture ratio implies the fund did better than the index when the index did well.

Capture ratio = Upside capture/Downside Capture

I had purposely indicated the >0 and <0 in bold brown. What if you could your own threshold?

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The Omega ratio allows us to do this by setting a minimum acceptable return (MAR) – which could also be 0%!

However, the Omega ratio does not calculate the CAGR. Instead, for a given MAR, it finds how many monthly/weekly/daily returns in a given sample set (over 1,2,… etc years) are above the MAR and how many below.

A positive return is one which is above the MAR and a negative return one below it.

Omega ratio = positive return spread/ negative return spread. The value depends on the MAR chosen by the user.

The value depends on the MAR chosen by the user. For those technically inclined, the spread is actually an area or rather the probability associated with the distribution.

A higher Omega ratio is better. A fund consistently having a higher Omega ratio that its index is a ‘good fund’.

Omega-ratio-mutual-fund-1png

This quantum long-term equity (QLTE) vs Sensex total returns index for an MAR of 10%.

Omega-ratio-mutual-fund-2

HDFC Equity vs BSE 500 (TRI)* with MAR of 10%. Notice that HDFC Equity has lower Omega ratio than QLTE and is not consistent in beating the benchmark.

* The appropriate benchmark is CNX 500, but the BSE 500 should be a reasonable replacement since TRI values are available.

Resources/References

Article about the Omega ratio from evestment.com

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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13 Comments

  1. Can you give me the omega index of HDFC Balanced, Tata Balanced ,ICICI Pru Balanced and Birla Sun life balanced funds?

  2. Very interesting article, Pattu sir. I’ve a doubt. How’s the return (positive/negative) calculated? Is it the % change over the previous (daily/weekly/monthly) value? Or is it the IRR over the time period?
    Regards

    1. Thank you. Consider an asymmetric bell curve and an MAR at the centre of it. The area of the curve above the MAR divided by the area of the curve below the MAR gives the omega ratio. In other words, it is the probability of getting returns above MAR to the probability of getting returns below MAR.

  3. Hi Pattu sir,
    I have been reading your post’s for quite a while now. I have tried to understand all the risk and return ratio’s you have talked about in your various post’s.
    Can you post a article on certain quantitative ratios that we can use to check scheme performance and decide on when to exit / enter a particular scheme.
    The reason for this is that I am developing a software which can calculate all of the ratio’s and return metric’s at regular interval’s and filter scheme’s according to the user defined filter criteria. Thereafter, the user can also go back in time and see how his mutual fund portfolio would have performed had he used the same criteria to select funds as on that date, something like mutual fund portfolio backtesting.
    According to you, are investor’s looking for such a tool to help them choose scheme’s and see where they are going wrong or was their decision right in the past?
    My intention is to empower investor’s to decide themselves rather then depending on advisor’s who only have their own financial interest in mind while recommending.
    Hope to hear from you soon.

    1. I have been saying for quite a while now that it is better to choose metrics that makes sense to an invesor – rolling returns or downside capture ratio etc. You will have to give a choice and let them decide

      1. Hi Pattu Sir,

        Thanks for replying. My software let’s the investor decide what ratio’s he want’s to use as well as the priority in which to use them so as to sort the scheme accordingly. I have incorporated all the ratio’s you have mentioned like rolling return’s, capture ratio, information ratio etc. along with different trailing periods for all like from 1 yr rolling return to 10 yr rolling return with 1 year interval breaks. And this is available at the end of any month since the inception of the scheme.

        But sir, according to you, are the investors interested in such a exhaustive software where they can also see their portfolio performance in the past based on their filter criteria? I hold your opinion in great regard since I have read your post’s and learnt a lot about selecting scheme’s from your post’s.

        Hope to hear from you.

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