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Explain where appraisal measures and associated metrics fall short

CFA® Level III · Performance Measurement · Portfolio Performance Evaluation · L3.PF.1.o

The idea

Every appraisal measure is a backward-looking estimate from one sample, so short records produce noisy numbers. The Sharpe ratio and M² use total volatility and assume roughly normal returns; option selling, leverage or smoothed prices can flatter them. The Treynor ratio, Jensen's alpha and the appraisal ratio depend on the chosen benchmark or factor model: a wrong market proxy mis-estimates beta and therefore alpha. The Sortino ratio depends on the minimum acceptable return chosen and needs enough below-target observations. Capture ratios depend on how up and down periods are defined and on the benchmark. Maximum drawdown and its duration are path dependent, driven by a few episodes and sensitive to the observation window. Smoothed values of illiquid assets understate volatility and can flatter most of these measures.

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