What Is the K-Ratio?
Let me explain the K-Ratio directly: it's a valuation metric that looks at how consistent an equity's returns are over time. You derive the data for this ratio from a value-added monthly index, or VAMI, which tracks the progress of a $1,000 initial investment in the security you're analyzing through linear regression.
Key Takeaways on the K-Ratio
Understand that K-Ratios measure an equity’s consistency of returns over time, and they're calculated using the value-added monthly index, known as VAMI. The process involves running a linear regression on the logarithmic cumulative return of a VAMI curve. What sets the K-Ratio apart is that it considers the returns themselves but also the order of those returns when measuring risk. Overall, this ratio evaluates the return of the security over time and serves as a solid tool for assessing equity performance because it factors in the return trend.
Formula and Calculation of the K-Ratio
You can calculate the K-Ratio using this formula: [insert formula description here, as the image isn't reproducible, but it involves the slope of the regression divided by the standard error of the slope, multiplied by the square root of the number of periods, all over the number of return periods]. In this setup, there are n return periods in the monthly return data. I'll keep it straightforward—run the linear regression on your VAMI data, and plug in the results accordingly.
What the K-Ratio Can Tell You
The K-Ratio was created by derivatives trader and statistician Lars Kestner to fill a gap in how we analyze returns. As an investor, your main concerns are returns and consistency, so Kestner designed this ratio to measure how steady a security, portfolio, or manager’s returns are over time. It accounts for the returns and the order in which they occur when assessing risk. You perform the calculation by running a linear regression on the logarithmic cumulative return of a VAMI curve, then use those results in the formula. The slope represents the return, which should be positive, and the standard error of the slope indicates the risk.
In 2003, Kestner updated the original K-Ratio by modifying the formula to include the number of return data points in the denominator. He made another adjustment in 2013, adding a square root calculation to the numerator.
Example of How to Use the K-Ratio
The K-Ratio measures a security's return over time, and it's a reliable tool for evaluating equity performance because it incorporates the return trend, rather than just point-in-time snapshots. You can use it to compare cumulative returns for different equities or equity managers over time. It stands out from measures like the Sharpe ratio by considering the order of returns. In practice, view the K-Ratio alongside other performance metrics.
Beyond individual stock returns, you can apply K-Ratios to style categories, fund managers, and even bonds. They'll vary across asset classes, such as domestic stocks versus bonds or emerging market stocks, within asset classes like large-cap versus small-cap, and by different time periods.
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