Traditional Risk Measures are Backwards

All investments inherently carry some level of risk, some of which can be measured. Traditional risk measures are based on historical data and are useful for quantitatively comparing a fund to the market or to other funds. While these measures may be used to inform future investment decisions, they are not intended to predict future risk levels or performance. To develop a robust investment strategy, we should first understand the traditional risk measures and the pitfalls that come with placing too much weight on them. Forward-looking risk management should instead rely on fundamental analysis. The five most common traditional risk measures are alpha, beta, R-squared, standard deviation, and the Sharpe ratio. 

Alpha and beta are two measures that allow an investor to compare their fund to a benchmark index like the S&P 500. For example, a positive alpha indicates overperformance and a beta below one indicates less volatility compared to the index. Alpha and beta can be useful for tracking relative success, but they do not provide any indication of the health of the fund itself. To complete the story, we need in-depth research of the fund holdings alongside contextual market conditions that can only be achieved through fundamental analysis. Understanding why a fund overperformed or withstood shocks better than the benchmark cannot be determined from a single number and therefore cannot inform future performance.

Similarly, R-squared measures the percentage of the fund’s performance attributable to the benchmark index. A fund with an R-squared value of 95 is highly correlated to the benchmark, with less correlation corresponding to lower R-squared values. More than anything, a high R-squared value informs a client that they would be better off investing directly in an index instead of paying higher fees for an actively managed fund. From an investment perspective, R-squared acts as a mere progress report as opposed to the detailed fundamental analysis necessary for informing future portfolio decisions, which may or may not have any bearing on the market’s historical performance.

Standard deviation is another measure of volatility that refers to how far an investment’s return deviated from its average return. If a fund has a high standard deviation, its prices vary widely from their average, indicating a risky investment. The standard deviation does little to inform how the fund will perform in the future, nor does it explain the reasons for a fund’s past performance. It essentially indicates volatility without providing any action items for the future.

Lastly, the Sharpe ratio measures risk-adjusted performance to determine whether the historical returns were explained by wise investment or from taking on too much risk. In general, the greater the Sharpe ratio, the better. The Sharpe ratio is most useful for comparing different fund options to one another for any given level of risk, but does not predict a fund’s future risk or returns. 

Performance benchmarks like these traditional risk measures each provide investors with a single number. To craft an investment strategy based on a few numerical values determined by historical averages is a misguided strategy when one should be more concerned about future earnings. Backward-looking risk measures force investors to focus on short-term performance rather than long-term results and therefore limit their ability to invest for optimized future earnings for their clients. Above all, traditional risk measures indicate how well an investor is doing at their job, but they do not tell the client how likely they are to reach their investment goals. To truly understand the risk of an investment and its potential trajectory, investors must engage in fundamental analysis with an effort to diversify holdings that can withstand future shocks.

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TrueShares Low Volatility Equity Income ETF is also subject to the following risk: As an ETF, the Fund is exposed to the additional risks, including: (1) concentration risk associated with Authorized Participants, market makers, and liquidity providers; (2) costs risks associated with the frequent buying or selling of Fund shares; (3) market prices may differ than the Fund’s net asset value; and (4) liquidity risk due to a potential lack of trading volume. Dividend Paying Security Risk. Securities that pay high dividends as a group can fall out of favor with the market, causing these companies to underperform companies that do not pay high dividends. Dividends may also be reduced or discontinued. Equity Market Risk. Common stocks are susceptible to general stock market fluctuations and to volatile increases and decreases in value as market confidence in and perceptions of their issuers change based on various and unpredictable factors including but not limited to: expectations regarding government, economic, monetary and fiscal policies; inflation and interest rates; economic expansion or contraction; and global or regional political, economic and banking crises. Market Capitalization Risk. The Fund may invest is securities across all market cap ranges. The securities of large-capitalization companies may be relatively mature compared to smaller companies and therefore subject to slower growth during times of economic expansion and may also be unable to respond quickly to new competitive challenges, such as changes in technology and consumer tastes. The securities of mid-capitalization companies may be more vulnerable to adverse issuer, market, political, or economic developments than securities of large-capitalization companies and generally trade in lower volumes and are subject to greater and more unpredictable price changes than large capitalization stocks. The securities of small-capitalization companies may be more vulnerable to adverse issuer, market, political, or economic developments than securities of large- or mid-capitalization companies and generally trade in lower volumes and are subject to greater and more unpredictable price changes than large- or mid-capitalization stocks. Depositary Receipts Risk. American Depositary Receipts (“ADRs”) have risks similar to those of foreign securities (political and economic conditions, changes in the exchange rates, etc.) and entitle the holder to all dividends and capital gains that are paid out on the underlying foreign shares.