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Sharpe Point: Risk Gauge is Misused
William F. Sharpe was probably the biggest expert in the
room when economists from around the world gathered
to hash out a pressing problem: How to gauge hedge-fund
risk. About 40 years ago, Dr. Sharpe created a simple cal-
culation for measuring the return that investors should
expect for the level of volatility they are accepting. In other
words: How much money do they stand to make compared
with the size of the up-and-down swings they will lose
sleep over?
The so-called Sharpe ratio became a cornerstone of
modern finance, as investors used it to help select money
managers and mutual funds. But the use of the ratio has
been criticized by many prominent academics—including
Dr. Sharpe himself.
The ratio is commonly used—“misused,” Dr. Sharpe
says—for promotional purposes by hedge funds. Hedge
funds, loosely regulated private investment pools, often
use complex strategies that are vulnerable to surprise
events and elude any simple formula for measuring risk.
“Past average experience may be a terrible predictor of
future performance,” Dr. Sharpe says.
Dr. Sharpe designed the ratio to evaluate portfolios of
stocks, bonds, and mutual funds. The higher the Sharpe
ratio, the better a fund is expected to perform over the
long term. However, at a time when smaller investors and
pension funds are pouring money into hedge funds, the
ratio can foster a false sense of security.
Dr. Sharpe says the ratio doesn’t foreshadow hedge-
fund woes because “no number can.” The formula can’t
predict such troubles as the inability to sell off investments
quickly if they start to head south, nor can it account for
extreme unexpected events. Long-Term Capital Manage-
ment, a huge hedge fund in Connecticut, had a glowing
Sharpe ratio before it abruptly collapsed in 1998 when
Russia devalued its currency and defaulted on debt. Plus,
hedge funds are generally secretive about their strategies,
making it difficult for investors to get an accurate picture
of risk.
Another problem with the Sharpe ratio is that it is
designed to evaluate the risk-reward profile of an inves-
tor’s entire portfolio, not small pieces of it. This shortcom-
ing is particularly telling for hedge funds.
Source: Ianthe Jeanne Dugan, “Sharpe Point: Risk Gauge is
Misused,” The Wall Street Journal, August 31, 2005, p. C1. © 2005
Dow Jones & Company, Inc. All rights reserved worldwide.
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P A R T V I I
Applied Portfolio Management
24.3
Performance Measurement with Changing
Portfolio Composition
We have seen already that the volatility of stock returns requires a very long observation
period to determine performance levels with any precision, even if portfolio returns are
distributed with constant mean and variance. Imagine how this problem is compounded
when portfolio return distributions are constantly changing.
It is acceptable to assume that the return distributions of passive strategies have constant
mean and variance when the measurement interval is not too long. However, under an
active strategy return distributions change by design, as the portfolio manager updates the
portfolio in accordance with the dictates of financial analysis. In such a case, estimating
various statistics from a sample period assuming a constant mean and variance may lead to
substantial errors. Let us look at an example.
Suppose that the Sharpe measure of the market index is .4. Over an initial period of
52 weeks, the portfolio manager executes a low-risk strategy with an annualized mean
excess return of 1% and standard deviation of 2%. This makes for a Sharpe measure of
.5, which beats the passive strategy. Over the next 52-week period this manager finds
that a high -risk strategy is optimal, with an annual mean excess return of 9% and stan-
dard deviation of 18%. Here, again, the Sharpe measure is .5. Over the 2-year period
our manager maintains a better-than-passive Sharpe measure.
Figure 24.5 shows a pattern of (annualized) quarterly returns that are consistent with
our description of the manager’s strategy of 2 years. In the first four quarters the excess
returns are 2 1%, 3%, 2 1%, and 3%, making for an average of 1% and standard
deviation of 2%. In the next four quarters the returns are 2 9%, 27%, 2 9%, 27%,
making for an average of 9% and standard deviation of 18%. Thus both years exhibit a
Sharpe measure of .5. However, over the eight-quarter sequence the mean and standard
deviation are 5% and 13.42%, respectively, making for a Sharpe measure of only .37,
apparently inferior to the passive strategy!
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