Omega Ratio Definition
Omega ratio is a weighted risk-return ratio for a given level of expected return that helps us to identify the chances of winning in comparison to loosing (higher the better). It also considers the third and fourth momentum effect i.e. skewness & kurtosis which gives this an immense usefulness in comparison to others.
For calculating the omega ratio, we require the cumulative excess return of the asset. Basically, we need to calculate all the high and low in a cumulative manner.
Formula of Omega Ratio
In simple form, the omega ratio formula can be understood as follows
Example of Omega Ratio
Standard Deviation = 6%, Mean Return = 5%
Return Earned in Past
Omega Ratio formula = ∑ Winning – Benchmarking / ∑ Benchmarking – Losing
= ∑ 20/ ∑ 10
Omega Ratio =2
Types of Omega Ratio
There are various measures that are used by the organization to check their risk in comparison to risk undertaken. As per the term structure theory of Fixed income, people are willing to take the risk if they are compensated in the form of higher returns. The higher return should be support by the higher risk but there should be trade-off so that higher returns can actually be seen after adjusting on a risk-adjusted basis.
Any ratio used to check the performance should be used in conjunction with another ratio not in isolation.
The following are different measures of omega ratio
- Treynor Ratio – Excess return earned/ Beta
- Sharpe Ratio – Excess return earned/ Standard Deviation
- Sortino Ratio – Excess return/ Downward Standard deviation
- Jensen Alpha – Return on a portfolio – Return as per Capital asset pricing model (CAPM) i.e. Excess Return in percentage
- It covers all the distribution whether normal or left or right-skewed.
- It covers all the risk-return attributes. Mean, Standard deviation, Kurtosis, skewness. This is the main advantage of using this ratio which is not tackled by any other similar ratio that makes it superior over others
- Omega ratio is useful in the case of a hedge fund where they invest in some exotic financial products where the asset does not have a distribution which is normal.
- Mostly used by a hedge fund who uses long/short strategies to earn an arbitrage.
- In real life no asset class can fit into the normal distribution, it provides the better result in this picture
- The omega calculation usefulness can be seen as it uses kithe actual return distribution instead of normal distribution. So the omega ratio responds accurately to the past analysis of the risk-return distribution of the investment being considered.
- The mutual fund invests in a diversified portfolio. It’s commonly used over here to check the performance and indicator of the likelihood of estimates.
- It rewards those portfolios which provide an excess return in comparison to losses.
- Easy to provide ranking to portfolio or asset class through omega ratio
- Heavy reliance on ratio can be a blunder because of using past data and nonstationarity in using the lookback data.
- It makes result complex for a small investor, only useful for the sophisticated investors
- Dependency on another ratio. It cannot independently rely only on itself.
- It is heavily affected by the outliers that make the result affected heavily.
- Value at Risk (VAR), Scenario Analysis, stress-based testing is also needed if the Asset under management(AUM) is high.
- Hedge funds charge fees in the form of carried interest and management fees for managing the fund. Omega helps to find out the ranking considering the effect of risk with return component but after considering the high fees of the fund, the result can show a slightly different picture than before considers the effect of that component
Omega ratio is useful in choosing the portfolio as per the desired profile of the investor. Some investors (Risk-averse people) want that they should at least earn the minimum rate of return that is saving rate provided by the bank or even more risk-averse people want that at least their capital should not be at risk. One can check their risk tolerance level and risk appetite ability to choose low or high omega ratio to align they require a risk-return profile with the particular class.
This has been a guide to what is Omega Ratio and its definition. Here we discuss formula to calculate the omega ratio along with its example, benefits, and limitations. You can learn more about budgeting from the following articles –