An evaluation of value at risk and the information ratio (for investors concerned with downside risk)

Publisher Summary This chapter evaluates two popular alternatives to the use of downside risk in portfolio management and demonstrates that on both a theoretical basis and an empirical basis, Value at risk (VaR) and the information ratio (IR) have serious weaknesses for investors who can identify some return that must be earned at minimum acceptable rate of return (MAR) in order to accomplish their goal. This affects asset allocation results as well as performance rankings. While both VaR and the IR fit nicely into the mean-variance framework, VaR is shown to be inappropriate for risk-averse investors and the information ratio is highlighted as misleading for investors who define risk as failure to achieve a particular MAR. In comparison to a downside risk approach, the dramatic difference in both performance measurement and asset allocation, provide powerful results that should give those using and promoting VaR an IR pause for thought. The chapter discusses VaR from a conceptual point of view and examines the question of whether VaR defines risk in a manner that is consistent with the risk preferences of investors.