Beware of Sharpe Objects
One of the most widely used metrics used to evaluate and pitch investment portfolios and managers was developed by the Nobel Prize researcher, William “Bill” Sharpe.
Coined the Sharpe Ratio, it is meant to offer investors a way to compare the performance of investment strategies to one another on a risk adjusted basis. As Bill Sharpe once said, we agree that when “properly used, it can improve investment management.”
As with many things, the key word in this phrase is “properly.”
As we recently wrote about Alpha pitches, unfortunately, we commonly see presentations of Sharpe ratios that aren’t that sharp.
Before we offer our views, let’s start with a reminder from Sharpe himself from a 2023 interview:
“Very often, the consultant or manager will show you Sharpe ratios for every investment in the portfolio, this fund, that fund, etc.
That doesn’t really help you much with what it was originally intended for.”
Before continuing, let that sink in a little.
Even though it is common to see investment advisers compare the Sharpe Ratios of investment funds inside a portfolio to one another, it was not intended to be used this way.
What’s Not Proper
Either inside or outside the investment world, if a case is being made for one product versus another, it is important that proper comparisons are made. If not, it may be appropriate to discard them all together.
As a quick cheat sheet on when it may be good to move on, the following is a list of Sharpe ratio comparisons that may be improper, with issues to consider below each bullet point:
- Hedge Funds to Public Funds
- The correlation and pricing of each strategy may not match
- Hedge Funds to Hedge Funds
- The correlation and pricing of each strategy may not match
- Private Funds to Most Any Other Type of Investment
- The correlation and pricing of each strategy may not match
Note that every sub-bullet is the same. It is important that metrics match or, as is more commonly said, apples are being compared to apples.
Common Problems
To make sure that Sharpe Ratio pitches aren’t improperly mixing things up, below are a few issues to watch for.
First, beware of presentations suggesting that a portfolio of high Sharpe Ratio managers will result in a high Sharpe Ratio portfolio. We would have to dive much deeper into investment geek speak to get this all in but in short, if the return streams of each manager are not highly correlated to one another, the comparisons are not apples to apples and the presentation should be discarded.
Next, another issue that commonly creates improper comparisons can be found in the Sharpe Ratio formula.
A key input is the variability of manager returns or standard deviation of the return streams.
If the frequency of the return marks or calculation periods do not match, the standard deviation metrics used to calculate each manager’s Sharpe Ratio will not match and, again, the comparison should be discarded.
An example of this can be the comparison of a daily priced public fund manager to a hedge fund or private investment that may only be priced once a month, once a quarter or even less, when capital statements are distributed.
This apples to orange mismatch of how either the return or risk side of the Sharpe Ratio equation is marked has become so common that it now has its own Cliff Asness of AQR coined phrase, Volatility Laundering, which can trend on Twitter.
A Sharpe Edge
As we said at the start of this post, when properly applied, the Sharpe Ratio can be a useful tool.
This ratio is often sold as the key definitive metric, though, so we are just offering a few thoughts to consider that we hope will provide investors with an edge.
When a Sharpe Ratio looks a little too good or is being pitched a little too hard, it can pay to ask sharp questions.
Related Reading:
The Ratio that Broke Investors’ Brains – Institutional Investor
The Sharpe Ratio – Stanford University – William Sharpe
Is Your Sharpe Ratio Lying to You? – QuantPy
The Road Less Traveled – Simple Alternatives Beware of Sharpe Objects