This post is part of an ongoing series on the Attain Capital blog that seeks to help investors understand the various metrics we use to evaluate managers. Stay tuned for future pieces!
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If you have been poking around the performance tables on Attain Capital’s website or elsewhere on the internet looking at alternative investments in things like managed futures and hedge funds, you have no doubt come across the statistic Sharpe ratio.
What is it? The Sharpe ratio is a risk adjusted return statistic which measures an investment’s return per unit of risk, with risk equal to the investment’s volatility. In simple terms – the Sharpe ratio measures return over volatility.
Sharpe = Return / Volatility
You’ll usually see some number like 0.59 or 1.82 or similar as the Sharpe ratio reading, and usually get confused as to what that really means for that investment. We all can picture in our minds what a 10% annual return looks like, but what does a 0.59 Sharpe mean?
The answer is that it means very little – when considered by itself. The whole idea of the Sharpe ratio is to allow for the comparison of different investments which have different characteristics. So a Sharpe ratio of 0.59 means very little by itself, but when compared to a Sharpe of 0.35 – we instantly know that the former is better (according to the Sharpe ratio). The 0.59 has more return per unit of risk than the 0.35 program.
The idea of the Sharpe Ratio was developed by Stanford professor Dr. William Forsyth Sharpe in 1966, based on an idea presented over a decade earlier by A. D. Roy, though it was eventually edited in 1994 by Sharpe himself to reflect the fact that a risk-free rate changes with time. The formula looks like this:
The point of the Sharpe, or any risk adjusted ratio, is to consider more than just the return when comparing investments. If all we needed to do was pick the investments with the highest returns, life would be pretty easy. But it isn’t that easy (by a long shot). In the real world, higher returns come with higher RISK, and comparing investments just on the basis of returns ignores that critical factor = RISK.
So the Sharpe ratio adds risk to the equation, essentially normalizing different programs returns by how volatile those returns have been. The Sharpe ratio looks to answer the question of which is better.
Would you prefer a program with a 35% annual rate of return and 25% annualized standard deviation of returns – or a program with a 10% annual return and 5% annualized standard deviation of returns. The answer isn’t obvious to many, as it is comparing apples to oranges (a high return/high risk program with a low return/low risk program); but the Sharpe cuts through all of that by serving up a single ratio to do the comparison. In this case, the latter program actually has a higher Sharpe ratio (1.6 to 1.32 using a risk free rate of 2%).
While this all seems well and fine, there are some big problems with the Sharpe ratio. For one, it only considers one single aspect of risk when computing a risk adjusted ratio. It only considers volatility of returns. There are several issues with this:
The largest issue of using volatility of returns, and more technically the standard deviation of returns, is that using such a calculation assumes a normal distribution of returns. That means the Sharpe ratio assumes returns are spread nice and evenly on a bell curve, like the heights of student’s in a grade school. Thing is, the financial world is anything but a nice smooth bell curve, with events which are deemed to happen once every 10,000 years on the bell curve happen once a year or more. Financial returns are not normally distributed, so using such a metric to gauge their performance is fraught with problems.
Secondly, using just the volatility of returns as the risk measure tends to reward programs which have short volatility profiles (small, consistent monthly winners offset by infrequent but large losing months – see FCI recently). It doesn’t take into consideration the skew and kurtosis in returns (the large negative outliers), and using it blindly will result in your portfolio being abnormally skewed to programs which tend to have nice and consistent returns (right up until they have big blow ups).
Finally, there is a lot more to risk than volatility. There is how far down the investment goes (max drawdown), how long the investment is down (max drawdown duration), how correlated it is to stocks, how much leverage is applied, and so on… just to name a few. Ignoring these in the name of being able to have a single ratio is dangerous at best.
For all these reasons and more, there are a variety of other risk metrics used in evaluating programs in managed futures and beyond, with the Sharpe ratio mostly derided among investment professionals – yet still latched onto by participants and used frequently in promotional material.