Investors Should Beware the Shortcomings of the Sharpe Ratio

One of the most pronounced developments in the finance field is the Sharpe ratio. Nobel Laureate William Sharpe developed this risk-adjusted measure in 1966. The ratio is computed by dividing excess return by the standard deviation to calculate return per unit of deviation.

The Sharpe Ratio

The Sharpe ratio was structured as forward-looking for determining excess return per total risk. The numerator of the ratio calculates as the expected portfolio return subtracted to the risk-free rate. The denominator is the standard deviation of the expected portfolio return. As a risk-free rate, generally, a one-year Treasury-bill rate is used in this ratio.

After frequent finance industry usage, the Sharpe ratio is used with realized returns instead of forward-looking, expected returns.

 is the annualized rate of portfolio return,

 is the annualized risk-free rate,

 is the annualized standard deviation.

The high Sharpe ratio is expected for better-performing funds. A higher Sharpe ratio indicates relatively excessive returns with a relatively low standard deviation.

The Sharpe ratio is used with realized returns instead of forward-looking, expected returns. A higher Sharpe ratio indicates relatively excessive returns with relatively low standard deviation.​

Shortcomings of the Sharpe Ratio

The Sharpe ratio is a helpful tool for investors to assess a portfolio’s relative performance with total risk metrics. However, investors need to be aware of the restrictions of the Sharpe ratio.

Illiquid investments underestimate the risk and smooth data, which results in the upward biased Sharpe ratio. Not only illiquidity risk but default risk and catastrophe instruments have an upwardly biased ratio.

According to Spurgin (2001), expanding the time frame increases the Sharpe ratio. While lengthening the time interval will not deteriorate the excess return in the numerator, raising the time frame will lower the standard deviation as a square root of the time interval in the denominator.
Not normally distributed investment returns with fat tails or negative skewness diminish standard deviation calculation quality, resulting in the inappropriate Sharpe ratio. The ratio only focuses on the individual investment and does not calculate the correlation among other assets or the portfolio. Also, the realized return-based Sharpe ratio is constructed on historical assumptions, and history may not repeat itself.

fat tailed distribution
Source: Wikipedia

Illiquid investments underestimate the risk and smooth data, which results in the upward biased Sharpe ratio. The ratio only focuses on the individual investment and does not calculate the correlation among other assets or the portfolio.​

Conclusion

WSJ’s interview with Dr. Sharpe says he does not use his ratio to evaluate hedge funds. He also states that anybody can game the ratio. Interestingly, he says, “I never named it the Sharpe ratio. I called it the Reward-to-Variability ratio.”

As investors, we need to benefit from various metrics and ratios and avoid adhering to limited formulas.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

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Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

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The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.