Graham harvey measure 1

What Is Graham-Harvey Measure 1?

The Graham-Harvey Measure 1 (GH1) is a metric used in investment performance measurement to evaluate the performance of an investment portfolio or manager. It is specifically designed to compare a fund's return against a benchmark that has been adjusted to exhibit the same level of volatility as the fund being evaluated. Unlike traditional performance metrics that might not adequately account for differing levels of risk, the Graham-Harvey Measure 1 aims to provide a more "apples-to-apples" comparison by equating risk levels. This measure helps assess whether a fund's superior returns are truly due to skill or simply a result of taking on greater risk.

History and Origin

The Graham-Harvey Measure 1 was developed by prominent finance academics John R. Graham and Campbell R. Harvey. Their work in the mid-1990s sought to address perceived shortcomings in existing methods of portfolio performance evaluation, particularly concerning the assessment of market timing ability. The measure builds upon their research, notably their 1996 paper titled "Market timing ability and volatility implied in investment newsletters' asset allocation recommendations," published in the Journal of Financial Economics.²³, ²⁴, ²⁵ This foundational paper, along with a subsequent 1997 article in the Financial Analysts Journal examining investment newsletters, provided the theoretical and empirical basis for the Graham-Harvey performance metrics.²⁰, ²¹, ²²

Key Takeaways

• Graham-Harvey Measure 1 (GH1) evaluates a fund's performance by comparing its return to a volatility-matched benchmark.
• It provides a more accurate assessment of performance by normalizing for differences in risk exposure.
• A positive Graham-Harvey Measure 1 suggests outperformance relative to a passively managed, equally volatile benchmark.
• The measure is rooted in academic research focusing on assessing market timing ability and overcoming limitations of earlier performance metrics.

Formula and Calculation

The Graham-Harvey Measure 1 (GH1) is calculated as the difference between the actual return of the fund ($R_{fund}$) and the return of a volatility-matched benchmark portfolio ($R_{benchmark,volatility-matched}$). The benchmark portfolio is constructed using a combination of the S&P 500 futures and a cash equivalent (such as a Treasury bill) to achieve the same volatility as the fund being evaluated over the given period.

The formula can be expressed as:

To determine $R_{benchmark,volatility-matched}$, one must first calculate the realized volatility of both the fund ($\sigma_{fund}$) and the S&P 500 ($\sigma_{S&P 500}$) over the evaluation period. Then, the S&P 500 futures are "levered" or "unlevered" (combined with cash) to match the fund's volatility.¹⁸, ¹⁹

Interpreting the Graham-Harvey Measure 1

Interpreting the Graham-Harvey Measure 1 provides insight into whether a fund manager's decisions, particularly their asset allocation and market timing efforts, have added value beyond what could be achieved by simply holding a passively managed portfolio with similar risk. A positive value for the Graham-Harvey Measure 1 indicates that the fund has outperformed a benchmark portfolio that was constructed to have the exact same volatility. This suggests that the manager exhibited skill in their investment strategies. Conversely, a negative Graham-Harvey Measure 1 implies underperformance, meaning that a passive strategy with comparable risk would have yielded better results. This evaluation helps investors differentiate between genuine skill and performance that is merely a result of taking on higher levels of market risk.

Hypothetical Example

Consider an actively managed mutual fund, Fund X, that aims to outperform the broad market. Over the past year, Fund X achieved a return of 12% with an annualized volatility of 18%. To evaluate its performance using the Graham-Harvey Measure 1, we would compare it to a synthetic benchmark portfolio.

Suppose the S&P 500 had a return of 10% with an annualized volatility of 15% during the same period. A hypothetical volatility-matched benchmark is created by "levering up" the S&P 500 to match Fund X's 18% volatility. If, through this levering, the volatility-matched benchmark achieved a hypothetical return of 11.5%, then the Graham-Harvey Measure 1 for Fund X would be:

GH1 = Fund X Return - Volatility-Matched Benchmark Return
GH1 = 12% - 11.5%
GH1 = 0.5%

In this scenario, a Graham-Harvey Measure 1 of 0.5% suggests that Fund X generated 0.5% more return than a comparable passive benchmark portfolio with the same level of risk, indicating a degree of outperformance.

Practical Applications

The Graham-Harvey Measure 1 is primarily used in the realm of investment performance measurement, especially for evaluating active managers. It provides a more nuanced view of performance compared to simpler metrics that may not fully account for differences in volatility. For instance, institutional investors and consultants might use the Graham-Harvey Measure 1 to:

• Assess Manager Skill: It helps determine if a fund manager's reported returns are genuinely superior due to active decision-making, such as strategic asset allocation or market timing, rather than simply higher risk exposure.
• Fund Selection: Investors can use it to compare various mutual funds or hedge funds, ensuring that funds are being compared on a more level playing field of risk.
• Academic Research: Academics utilize the Graham-Harvey Measure 1 in studies analyzing manager effectiveness and the viability of strategies like market timing ability. For example, John Graham and Campbell Harvey's surveys of Chief Financial Officers (CFOs) have shed light on how corporate executives view various aspects of corporate finance, including their perceptions of market conditions for issuing equity and debt.¹⁵, ¹⁶, ¹⁷

Limitations and Criticisms

While the Graham-Harvey Measure 1 offers a valuable framework for performance evaluation by controlling for volatility, it is not without its limitations. One key aspect is the assumption that the investor has the ability to "lever" or "unlever" the benchmark (e.g., S&P 500 futures and cash) to perfectly match the fund's risk profile.¹⁴ In practice, this might involve borrowing or lending at risk-free rates, which may not always be feasible or available to all investors at theoretical rates.

Furthermore, the measure is closely tied to evaluating market timing ability, a strategy that faces significant criticism. Many academics and financial professionals argue that consistently and successfully timing the market is extremely difficult, if not impossible, for most investors.¹³ Factors such as transaction costs, taxes, and the inherent randomness of market movements can erode any potential gains from trying to predict short-term price fluctuations.¹⁰, ¹¹, ¹² As noted by Forbes, successful market timing often involves navigating false signals and sudden market reversals that can severely damage returns.⁹ This persistent challenge in market timing suggests that even with sophisticated measures like the Graham-Harvey Measure 1, the underlying difficulty of consistently outperforming a passive investing strategy remains.

Graham-Harvey Measure 1 vs. Graham-Harvey Measure 2

The Graham-Harvey Measure 1 (GH1) and Graham-Harvey Measure 2 (GH2) are both tools developed by John Graham and Campbell Harvey to evaluate portfolio performance, but they differ in their approach to volatility matching.

The core distinction lies in which entity is adjusted to match the volatility of the other. The Graham-Harvey Measure 1 (GH1) adjusts a passive market benchmark, such as the S&P 500 combined with cash, to precisely match the realized volatility of the fund being evaluated.⁷, ⁸ The measure then calculates the difference between the fund's return and this volatility-matched benchmark's return.⁶

Conversely, the Graham-Harvey Measure 2 (GH2) takes the opposite approach: it adjusts the fund's recommended investment strategies (typically by combining them with a Treasury bill) to match the volatility of a common benchmark, usually the S&P 500.⁴, ⁵ This means that with GH2, all funds are compared on a common footing of market volatility, assuming the investor can lever the fund's returns to the market's risk level.³ Both measures aim to provide a clearer picture of an active manager's skill by normalizing for risk, but they offer different perspectives depending on whether the fund or the benchmark is the point of volatility adjustment.

FAQs

What is the primary purpose of the Graham-Harvey Measure 1?

The primary purpose of the Graham-Harvey Measure 1 is to assess the performance of an investment fund or manager by comparing its return to a hypothetical passive benchmark that has been adjusted to have the exact same volatility. This helps to isolate genuine manager skill from returns simply attributed to higher risk-taking.

How does Graham-Harvey Measure 1 differ from traditional performance metrics like the Sharpe ratio?

While both the Graham-Harvey Measure 1 and the Sharpe ratio are used in investment performance measurement, GH1 directly creates a volatility-matched benchmark for comparison, explicitly addressing cases where funds have significantly different risk profiles from a standard benchmark. Traditional measures like the Sharpe ratio assess risk-adjusted return but don't always create a directly comparable volatility-matched portfolio.¹, ²

Can the Graham-Harvey Measure 1 be used for all types of portfolios?

The Graham-Harvey Measure 1 is particularly useful for evaluating actively managed portfolios where market timing and tactical asset allocation decisions are made. While theoretically applicable to various portfolios, its utility shines when assessing managers who attempt to adjust their exposure to market risk over time.