What is the K-Ratio?

What is the K-Ratio?

The K-ratio is a valuation metric that examines the consistency of an equity’s return over time. The data for the ratio is derived from a value-added monthly index (VAMI), which uses linear regression to track the progress of a $1,000 initial investment in the security being analyzed.

K-ratios measure an equity’s consistency of returns over time, calculated using the value-added monthly index (VAMI).

The calculation involves running a linear regression on the logarithmic cumulative return of a Value-Added Monthly Index (VAMI) curve.

The K-ratio takes into account the returns themselves, but also the order of those returns in measuring risk.

History of the K-Ratio

Lars Kestner created the K-Ratio in 1996 to measure the overall profitability of a strategy. The ratio was designed so that an investor or financial manager could look at a data set and try to obtain a straight line with little deviation. This would help to signify that they are looking at an asset or investment product with a lucrative return.

The K-Ratio, according to Kestner, was introduced as a complementary ratio to the Sharpe Ratio. Over the years, Kestner made minor adjustments to the ratio, including adjustment factors for different types of return observations and different return periods.

Calculating K-ratio

As per the K-ratio definition, it can be calculated with the help of a simple formula.

K-ratio = (Slope logVAMI regression line) / n (Standard Error of Slope)

Here, the value of ‘n’ is known to represent the number of return periods in the return data of the given month.

What are the uses of K-Ratio?

K-ratio has lot of benefits for financial professionals like fund managers and even stock market enthusiasts who would like to know more about particular asset before investing. It is highly useful tool that gives predictive information about various assets.

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While Lars Kestner was developed by a statistician, it has been used worldwide and in 2003 has seen an updated version of K-ratio. The last known update to K-ratio was done in 2013, where he introduced square root calculation to numerator.

K-ratio is mainly used for to track and analyze the long-term performance of equities and assets.

What the K-Ratio Can Tell You

The K-ratio was developed by derivatives trader and statistician Lars Kestner as a way to address a perceived gap in how returns had been analyzed. Because an investor’s key interests are returns and consistency, Kestner designed his K-ratio to measure risk versus return by analyzing how steady a security, portfolio, or manager’s returns are over time.

The K-ratio takes into account the returns, but also the order of those returns in measuring risk. The calculation involves running a linear regression on the logarithmic cumulative return of a Value-Added Monthly Index (VAMI) curve. The results of the regression are then used in the K-ratio formula. The slope is the return, which should be positive, while the standard error of the slope represents the risk.

In 2003, Kestner introduced a modified version of his original K-ratio, which changed the formula of the calculation to include the number of return data points in the denominator. He introduced a further modification, which added a square root calculation to the numerator, in 2013.

Example of How to Use the K-Ratio

The ratio measures the return of the security over time and it is considered to be a good tool to measure the performance of equities because it takes the return trend into account, versus point-in-time snapshots.

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The K-ratio allows for a comparison of cumulative returns for different equities (and equity managers) returns over time. It differs from the widely used Sharpe measure by taking into account the order in which returns occur. In practice, the K-ratio is designed to be viewed in tandem with and in addition to other measures of performance.

In addition to their use in analyzing individual stock returns, style categories, and fund managers, K-ratios can also be calculated for bonds. K-ratios will differ across asset classes (domestic stocks versus bonds versus emerging market stocks), within asset classes (e.g., large-cap versus small-cap) and by time period.