It was a mathematical pursuit of getting the most optimum portfolio return in theory. It is available to most of the MBAa and CFAs and ofcourse, the theory is controversial, if it was correct, then most MBA and CFA would have been billionaire by now, things to add here is that most hedge funds around the worlds have billions of dollar invested on these thesis.
below is the text from papers of prof. Shiller from yale.
So, all I have to do is fool people into thinking I have a high Sharpe ratio for a while. So, what do I do? Well, there's an interesting paper on this by--there's a lot of papers on this, but I'm going to cite one--by Professor Goetzmann and co-authors. It's actually Goetzmann, Ibbotson, Spiegel, and Welch. Maybe I'll put all their names on. Roger Ibbotson is a professor here, Matt Spiegel, and Ivo Welch.
What they did is they calculated the optimal strategy for someone who wants to play games with a Sharpe ratio. So, you want to fool investors and get a spuriously high Sharpe ratio. And they found out what the optimal strategy is. And that is to sell off the tails of your distribution of returns. So, if your return distribution looks like this--this is return, OK? And you have a probability distribution; say a bell-shaped curve, OK? And so the mean and standard deviation of this would be the inputs to the Sharpe ratio. But if you're cynical and you want to play tricks, what you can do is sell the upper tail. These are very unlikely good events. Sell them and get money now, and then double up on the lower tail. So, you push the lower tail to something like that, and you wipe out the upper tail, so it goes like that, all right? So, that means you'll get money, because you sold the upper tail. You would do that by selling calls--we haven't talked about options yet--but you can do it by selling out-of-the-money calls. And you would do this by writing out-of-the-money puts.
OK, but what you do it you make it, so that if there's really a bad year, it's going to be a doozer bad year for your investors. And if there's ever a good year, then, hey, you won't get it. But these good or bad years occur only infrequently. So, in the meantime, you're making profits from these sales and you have a high Sharpe ratio. But little do they know that you sold off the tails. And so, nothing happens for many years and you just look like the best guy there. So, it turns out that this is not just academic. There was a company called Integral Investment Management that did something like this strategy. It was a hedge fund. So, it was Integral Investment Management. It did something like this, by trading in options. And, it got lots of investors to put millions in them.
Notably, the Art Institute of Chicago put $43 million into this fund and its associated funds. And then, in 2001, when the market dropped a lot, Art Institute of Chicago was wiped out. They lost almost all of their $43 million. And so, they got really angry, and they sued this company. Because they said, you didn't tell us. What have you been doing? And then, the company pointed out, in its defense, that it actually said somewhere in the fine print, that if markets go down more than 30%, there would be a problem. And somehow, nobody at the Art Institute read that or figured it out. They thought the guy was a genius, because this company had the highest Sharpe ratio in the industry, all right? You see what they're doing? They're playing tricks. They're making it look like there's less risk than there really is. And there's a strategy to do that.
It didn't end well for Integral Investment Management, because the Art Institute of Chicago managed to stick them on other things--they disclosed it. They told people that they were doing this strategy. The artists didn't figure it out. But there were other dishonesties that they nailed these guys on.
What Goetzmann and his co-authors did is, they showed that you can play tricks with the--you can play a lot of tricks in finance. But one of them is to play a trick with the Sharpe ratio. But their trick was very explicit. It involved particular portfolio composition involving options, and any professional would immediately know that that's a trick. And it didn't work for these guys; they were too aggressive in their manipulation. But you can do subtler things as a portfolio manager to get your Sharpe ratio up. Instead of manipulating with special derivatives positions, you could just buy companies that have large left tails. They have a small probability of massive losses.
