M-Squared: Decoding the Modigliani Risk Adjusted Performance and Money Supply

M-Squared: Decoding the Modigliani Risk-Adjusted Performance and Money Supply

INTRO: M-Squared is not one, but two, entirely different concepts. It can refer to the Modigliani Risk-Adjusted Performance (RAP), a financial tool that helps to compare the performance of investments. It can also refer to M2, a measure of the money supply in an economy. Both are important, but they operate in different realms. Understanding these two concepts will give you a significant advantage in the financial world.

Key Takeaway: M-Squared encompasses both a performance metric for investments (RAP) and a measure of money supply (M2), each offering crucial insights into financial markets.

Modigliani Risk-Adjusted Performance (RAP)

Definition: The Modigliani Risk-Adjusted Performance (RAP), often referred to as M-Squared, is a performance metric used in finance to evaluate the risk-adjusted return of an investment portfolio. It is an enhancement of the Sharpe ratio, offering a more intuitive interpretation by expressing the portfolio's return in terms of the benchmark's return. It aims to answer the question: “If we had the same risk as the benchmark, what return would our portfolio produce?”

Key Takeaway: M-Squared is a risk-adjusted performance measure that translates a portfolio's return into a return relative to a benchmark with the same level of risk.

Mechanics: M-Squared works by hypothetically adjusting a portfolio's risk to match the risk of a benchmark, such as the market index (S&P 500). Here’s how it works:

1. Calculate the Portfolio's Sharpe Ratio: This is the starting point. The Sharpe ratio measures the excess return of an investment (return above the risk-free rate) per unit of total risk (standard deviation). The formula is: Sharpe Ratio = (Rp - Rf) / σp, where Rp is the portfolio's return, Rf is the risk-free rate, and σp is the portfolio's standard deviation.
2. Adjust the Portfolio's Risk: This is the core of the M-Squared calculation. The portfolio is leveraged or deleveraged (i.e. increased or decreased using debt) so that its standard deviation matches that of the benchmark. For instance, if the portfolio’s standard deviation is lower than the benchmark’s, the portfolio is leveraged. If it’s higher, it’s deleveraged.
3. Calculate the Adjusted Portfolio Return: Once the portfolio's risk is adjusted to match the benchmark’s, the adjusted portfolio return is calculated. The formula is: M-Squared = Rf + (Sharpe Ratio * σb), where σb is the benchmark's standard deviation.

In essence, M-Squared tells you what the portfolio's return would be if it had the same level of risk as the benchmark.

Trading Relevance: M-Squared is primarily used by institutional investors and portfolio managers to compare the performance of different investment strategies. It allows them to assess which strategies are most efficient at generating returns, considering the level of risk taken. Traders can indirectly benefit by understanding how institutional investors evaluate fund managers, as this can influence market sentiment and asset prices. If a fund manager consistently delivers a high M-Squared, their fund may attract more investment, potentially driving up the prices of the assets they hold.

Risks: The primary risk associated with M-Squared is its reliance on historical data and assumptions. The future performance of an investment portfolio is not guaranteed by its past M-Squared. Also, the benchmark chosen can significantly affect the M-Squared value. Finally, it does not account for all types of risk, such as liquidity risk or tail risk (extreme market events). It’s essential to consider these limitations when interpreting M-Squared.

History/Examples: The Modigliani and Modigliani (Franco and Leah Modigliani) developed M-Squared as an alternative to the Sharpe Ratio in the late 1990s. While the Sharpe Ratio is easier to calculate, its interpretation can be less intuitive. Imagine two funds: Fund A and Fund B. Fund A has a higher return, but also a higher standard deviation (risk) than Fund B. The Sharpe ratio might make it difficult to compare them directly. M-Squared resolves this by adjusting the risk to the same level, making the comparison more straightforward. If Fund A has a higher M-Squared than Fund B, it means that Fund A would generate a higher return than Fund B if they had the same level of risk. In the context of the crypto market, this could be used to compare the performance of different trading strategies or funds, such as a Bitcoin trading strategy compared to an Ethereum staking strategy.

M2: Money Supply

Definition: M2 is a measure of the money supply in an economy. It represents the total amount of money circulating in a country, including physical currency, checking accounts, savings deposits, money market funds, and other easily convertible forms of money. It is a key indicator used by economists and central banks to understand the overall liquidity and economic health of a country.

Key Takeaway: M2 is a broad measure of the money supply, reflecting the total amount of readily available money in an economy.

Mechanics: M2 is calculated by aggregating several components of the money supply. This typically includes:

1. M1: This is the most liquid component and includes physical currency in circulation and checking accounts.
2. Savings Deposits: These are funds held in savings accounts at banks and other financial institutions.
3. Money Market Funds: These are investment funds that invest in short-term debt securities.
4. Other Highly Liquid Assets: This can include small-denomination time deposits and other assets that can be easily converted into cash.

The specific formula can vary slightly depending on the country, but the general principle is the same: M2 = M1 + Savings Deposits + Money Market Funds + Other Liquid Assets.

Central banks, like the Federal Reserve in the United States, closely monitor M2 to gauge the level of liquidity in the economy and to make decisions about monetary policy.

Trading Relevance: The M2 money supply can influence asset prices, including cryptocurrencies. An increase in M2 can indicate an increase in liquidity in the economy. This can lead to increased investment, including in riskier assets like crypto. Conversely, a decrease in M2 can signal a decrease in liquidity, potentially leading to a sell-off in crypto and other assets. Traders often monitor M2 data to anticipate changes in market sentiment and adjust their trading strategies accordingly. For example, if M2 is increasing significantly, a trader might be more inclined to take on more risk, potentially buying Bitcoin or other altcoins. If M2 is decreasing, a trader might become more cautious, possibly reducing their exposure to riskier assets.

Risks: The primary risk associated with M2 is that it can be a lagging indicator, meaning it reflects past economic conditions rather than current ones. Changes in M2 do not always immediately translate into changes in asset prices. Furthermore, the relationship between M2 and asset prices is complex and influenced by many other factors, such as inflation, interest rates, and investor sentiment. It is important not to make trading decisions solely based on M2 data.

History/Examples: The concept of measuring money supply dates back to the early days of economic analysis. The different measures, such as M1, M2, and M3, were developed to provide a more detailed understanding of the money circulating in an economy. In the wake of the 2008 financial crisis, many central banks, including the Federal Reserve, significantly increased M2 through quantitative easing (QE). This was done to stimulate the economy and prevent a deflationary spiral. While the impact of QE on asset prices is debated, it is clear that the increase in liquidity contributed to the rise of many asset prices, including cryptocurrencies. In the context of crypto, the Federal Reserve's response to the COVID-19 pandemic, including increased M2, coincided with the start of the bull run in 2020-2021. Understanding these relationships can help traders anticipate market movements.