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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.
Investors Should Beware the Shortcomings of the Sharpe Ratio
- by Mehmet E. Akgul
- July 14, 2018
One of the most pronounced developments in the finance field is the Sharpe ratio. This risk-adjusted measure was developed by Nobel Laureate William Sharpe in 1966. The ratio is computed with dividing excess return to 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, 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 ratio of indicates relatively excessive returns with relatively low standard deviation.
The Sharpe ratio is used with realized returns instead of forward-looking, expected returns. A higher Sharpe ratio of indicates relatively excessive returns with relatively low standard deviation.
Shortcomings of the Sharpe Ratio
The Sharpe ratio is a very useful tool for investors to assess the relative performance of a portfolio with total risk metrics. However, investors need to aware of the restrictions of the Sharpe ratio.
Illiquid investments underestimate the risk and smooth data, which results in the upward biased the 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, increasing 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 the quality of standard deviation calculation, which results 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, history may not repeat itself.
Illiquid investments underestimate the risk and smooth data, which results in the upward biased the Sharpe ratio. The ratio only focuses on the individual investment and does not calculate the correlation among other assets or the portfolio.
Conclusion
According to WSJ’s interview with Dr. Sharpe, he says he does not use his own 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 an investor, we need to benefit a variety of metrics and ratios and avoid adhering 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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Mehmet E. Akgul