Sharpe ratio

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In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure,

and the reward-to-variability ratio) measures the performance of an investment (e.g.,
a security or portfolio) compared to a risk-free asset, after adjusting for its risk. It is
defined as the difference between the returns of the investment and the risk-free return,
divided by the standard deviation of the investment (i.e., its volatility). It represents the
additional amount of return that an investor receives per unit of increase in risk.
It was named after William F. Sharpe,[1] who developed it in 1966.

Contents

 1Definition
 2Use in finance
 3Tests
 4History
 5Examples
 6Strengths and weaknesses
o 6.1Drawback as fund selection criteria
 7See also
 8References
 9Further reading
 10External links

Definition[edit]
Since its revision by the original author, William Sharpe, in 1994, [2] the ex-ante Sharpe
ratio is defined as:
where  is the asset return,  is the risk-free return (such as a U.S. Treasury
security).  is the expected value of the excess of the asset return over the
benchmark return, and  is the standard deviation of the asset excess return.
The ex-post Sharpe ratio uses the same equation as the one above but with realized
returns of the asset and benchmark rather than expected returns; see the second
example below.
The information ratio is similar to the Sharpe ratio, the main difference being that the
Sharpe ratio uses a risk-free return as benchmark whereas the information ratio
uses a risky index as benchmark (such as the S&P500).

Use in finance[edit]
The Sharpe ratio characterizes how well the return of an asset compensates the
investor for the risk taken. When comparing two assets versus a common
benchmark, the one with a higher Sharpe ratio provides better return for the same
risk (or, equivalently, the same return for lower risk).
Namely, Sharpe ratio considers the ratio of a given stock's excess return to its
corresponding standard deviation. Excess return is considered as a performance
indicator of stock fund.[3]
However, like any other mathematical model, it relies on the data being correct and
enough data is given that we observe all risks that the algorithm or strategy is
actually taking. Ponzi schemes with a long duration of operation would typically
provide a high Sharpe ratio when derived from reported returns, but eventually the
fund will run dry and implode all existing investments when there are no more
incoming investors willing to participate in the scheme and keep it going. Similarly,
selling very low-strike put options may appear to have a very high Sharpe ratios
over the time-span of even years, because low-strike puts act like insurance. On the
contrary to the perceived Sharpe ratio, selling puts is a high-risk endeavor that's
unsuitable for low-risk accounts due to their maximal potential loss. If the underlying
security ever crashes to zero or defaults and investors want to redeem their puts for
the entire equity valuation, all of the since-obtained profits and much of the
underlying investment could be wiped out.
Thus the data for the Sharpe ratio must be taken over a long enough time-span to
integrate all aspects of the strategy to a high confidence interval. For example, data
must be taken over decades if the algorithm sells an insurance that involves a high
liability payout once every 5-10 years, and a High-frequency trading algorithm may
only require a week of data if each trade occurs every 50 milliseconds, with care
taken toward risk from unexpected but rare results that such testing did not capture
(See flash crash). Additionally, when examining the investment performance of
assets with smoothing of returns (such as with-profits funds), the Sharpe ratio
should be derived from the performance of the underlying assets rather than the
fund returns (Such a model would invalidate the aforementioned Ponzi scheme, as
desired).
Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank
the performance of portfolio or mutual fund managers.
Berkshire Hathaway had a Sharpe ratio of 0.76 for the period 1976 to 2011, higher
than any other stock or mutual fund with a history of more than 30 years. The stock
market had a Sharpe ratio of 0.39 for the same period. [4]

Tests[edit]
Several statistical tests of the Sharpe ratio have been proposed. These include
those proposed by Jobson & Korkie[5] and Gibbons, Ross & Shanken.[6]

History[edit]
In 1952, Arthur D. Roy suggested maximizing the ratio "(m-d)/σ", where m is
expected gross return, d is some "disaster level" (a.k.a., minimum acceptable return,
or MAR) and σ is standard deviation of returns.[7] This ratio is just the Sharpe ratio,
only using minimum acceptable return instead of the risk-free rate in the numerator,
and using standard deviation of returns instead of standard deviation of excess
returns in the denominator. Roy's ratio is also related to the Sortino ratio, which also
uses MAR in the numerator, but uses a different standard deviation (semi/downside
deviation) in the denominator.
In 1966, William F. Sharpe developed what is now known as the Sharpe ratio.
[1]
 Sharpe originally called it the "reward-to-variability" ratio before it began being
called the Sharpe ratio by later academics and financial operators. The definition
was:
Sharpe's 1994 revision acknowledged that the basis of comparison should be an
applicable benchmark, which changes with time. After this revision, the definition
is:
Note, if Rf is a constant risk-free return throughout the period,
Recently, the (original) Sharpe ratio has often been challenged with
regard to its appropriateness as a fund performance measure during
evaluation periods of declining markets.[8]

Examples[edit]
Example 1
Suppose the asset has an expected return of 15% in excess of the risk
free rate. We typically do not know if the asset will have this return;
suppose we assess the risk of the asset, defined as standard deviation of
the asset's excess return, as 10%. The risk-free return is constant. Then
the Sharpe ratio (using the old definition) will be
Example 2
For an example of calculating the more commonly used ex-post Sharpe
ratio—which uses realized rather than expected returns—based on the
contemporary definition, consider the following table of weekly returns.

S&P 500 total

Date Asset Return Excess Return
return

7/6/2012 -0.0050000 -0.0048419 -0.0001581

7/13/201
0.0010000 0.0017234 -0.0007234
2
7/20/201
0.0050000 0.0046110 0.0003890
2

We assume that the asset is something like a large-cap U.S. equity fund
which would logically be benchmarked against the S&P 500. The mean of
the excess returns is -0.0001642 and the (sample) standard deviation is
0.0005562248, so the Sharpe ratio is -0.0001642/0.0005562248, or
-0.2951444.
Example 3
Suppose that someone currently is invested in a portfolio with an
expected return of 12% and a standard deviation of 10%. The risk-free
rate of interest is 5%. What is the Sharpe ratio?
The Sharpe ratio is: 

Strengths and weaknesses[edit]

A negative Sharpe ratio means the portfolio has underperformed its
benchmark. All other things being equal, an investor wants to increase a
positive Sharpe ratio, by increasing returns and decreasing volatility.
However, a negative Sharpe ratio can be brought closer to zero by either
increasing returns (a good thing) or increasing volatility (a bad thing).
Thus, for negative returns, the Sharpe ratio is not a particularly useful tool
of analysis.[citation needed]
The Sharpe ratio's principal advantage is that it is directly computable
from any observed series of returns without need for additional
information surrounding the source of profitability. Other ratios such as
the bias ratio have recently been introduced into the literature to handle
cases where the observed volatility may be an especially poor proxy for
the risk inherent in a time-series of observed returns. [citation needed]
While the Treynor ratio works only with systematic risk of a portfolio, the
Sharpe ratio observes both systematic and idiosyncratic risks.
The returns measured can be of any frequency (i.e. daily, weekly,
monthly or annually), as long as they are normally distributed, as the
returns can always be annualized. Herein lies the underlying weakness of
the ratio - not all asset returns are normally distributed. Abnormalities
like kurtosis, fatter tails and higher peaks, or skewness on
the distribution can be problematic for the ratio, as standard deviation
doesn't have the same effectiveness when these problems exist.
Sometimes it can be downright dangerous to use this formula when
returns are not normally distributed.[9]
Because it is a dimensionless ratio, laypeople find it difficult to interpret
Sharpe ratios of different investments. For example, how much better is
an investment with a Sharpe ratio of 0.5 than one with a Sharpe ratio of
-0.2? This weakness was well addressed by the development of
the Modigliani risk-adjusted performance measure, which is in units of
percent return – universally understandable by virtually all investors. In
some settings, the Kelly criterion can be used to convert the Sharpe ratio
into a rate of return. (The Kelly criterion gives the ideal size of the
investment, which when adjusted by the period and expected rate of
return per unit, gives a rate of return.)[10]
The accuracy of Sharpe ratio estimators hinges on the statistical
properties of returns, and these properties can vary considerably among
strategies, portfolios, and over time.[11]
Drawback as fund selection criteria[edit]
Bailey and López de Prado (2012)[12] show that Sharpe ratios tend to be
overstated in the case of hedge funds with short track records. These
authors propose a probabilistic version of the Sharpe ratio that takes into
account the asymmetry and fat-tails of the returns' distribution. With
regards to the selection of portfolio managers on the basis of their Sharpe
ratios, these authors have proposed a Sharpe ratio indifference
curve[13] This curve illustrates the fact that it is efficient to hire portfolio
managers with low and even negative Sharpe ratios, as long as their
correlation to the other portfolio managers is sufficiently low.
Goetzmann, Ingersoll, Spiegel, and Welch (2002) determined that the
best strategy to maximize a portfolio's Sharpe ratio, when both securities
and options contracts on these securities are available for investment, is
a portfolio of one out-of-the-money call and one out-of-the-money put.
This portfolio generates an immediate positive payoff, has a large
probability of generating modestly high returns, and has a small
probability of generating huge losses. Shah (2014) observed that such a
portfolio is not suitable for many investors, but fund sponsors who select
fund managers primarily based on the Sharpe ratio will give incentives for
fund managers to adopt such a strategy. [14]

See also[edit]
 Bias ratio
 Calmar ratio
 Capital asset pricing model
 Coefficient of variation
 Hansen–Jagannathan bound
 Information ratio
 Jensen's alpha
 List of financial performance measures
 Modern portfolio theory
 Omega ratio
 Risk adjusted return on capital
 Roy's safety-first criterion
 Signal-to-noise ratio
 Sortino ratio
 Sterling ratio
 Treynor ratio
 Upside potential ratio
 V2 ratio
 Z score

References[edit]
1. ^ Jump up to:    Sharpe, W. F. (1966). "Mutual Fund Performance". Journal of
a b

Business.  39  (S1): 119–138.  doi:10.1086/294846.

2. ^ Sharpe, William F. (1994). "The Sharpe Ratio". The Journal of Portfolio
Management.  21(1): 49–58. doi:10.3905/jpm.1994.409501. Retrieved  June
12,  2012.
3. ^ Gatfaoui, Hayette. "Sharpe Ratios and Their Fundamental Components: An
Empirical Study".  IESEG School of Management.
4. ^ http://docs.lhpedersen.com/BuffettsAlpha.pdf
5. ^ Jobson JD; Korkie B (September 1981). "Performance hypothesis testing with the
Sharpe and Treynor measures".  The Journal of Finance. 36 (4): 888–
908.  doi:10.1111/j.1540-6261.1981.tb04891.x. JSTOR 2327554.
6. ^ Gibbons M; Ross S; Shanken J (September 1989). "A test of the efficiency of a
given portfolio". Econometrica. 57 (5): 1121–
1152.  CiteSeerX 10.1.1.557.1995. doi:10.2307/1913625. JSTOR 1913625.
7. ^ Roy, Arthur D. (July 1952). "Safety First and the Holding of
Assets". Econometrica. 20 (3): 431–450. doi:10.2307/1907413. JSTOR 1907413.
8. ^ Scholz, Hendrik (2007). "Refinements to the Sharpe ratio: Comparing alternatives
for bear markets".  Journal of Asset Management.  7 (5): 347–
357.  doi:10.1057/palgrave.jam.2250040.
9. ^ "Understanding The Sharpe Ratio". Retrieved  March 14,  2011.
10. ^ Wilmott, Paul (2007).  Paul Wilmott introduces Quantitative Finance  (Second ed.).
Wiley. pp.  429–432.  ISBN  978-0-470-31958-1.
11. ^ Lo, Andrew W. (July–August 2002). "The Statistics of Sharpe Ratios".  Financial
Analysts Journal. 58 (4).
12. ^ Bayley, D. and M. López de Prado (2012): "The Sharpe Ratio Efficient Frontier",
Journal of Risk, 15(2), pp.3-44. Available at https://ssrn.com/abstract=1821643
13. ^ Bailey, D. and M. Lopez de Prado (2013): "The Strategy Approval Decision: A
Sharpe Ratio Indifference Curve approach", Algorithmic Finance 2(1), pp. 99-109
Available at https://ssrn.com/abstract=2003638
14. ^ Shah, Sunit N. (2014),  The Principal-Agent Problem in Finance, CFA Institute,
p. 14

 Goetzmann, William; Ingersoll, Jonathan; Spiegel, Matthew; Welch, Ivo

(2002), Sharpening Sharpe Ratios  (PDF), National Bureau of Economic
Research.
 Shah, Sunit N. (2014), The Principal-Agent Problem in Finance, CFA
Institute
Further reading[edit]
 Bacon Practical Portfolio Performance Measurement and Attribution 2nd Ed:
Wiley, 2008. ISBN 978-0-470-05928-9
 Bruce J. Feibel. Investment Performance Measurement. New York: Wiley,
2003. ISBN 0-471-26849-6

External links[edit]
 The Sharpe ratio
 Generalized Sharpe Ratio
 All Hail the Sharpe Ratio - Uses and abuses of the Sharpe Ratio
 What is a good Sharpe Ratio? - Some example calculations of Sharpe ratios
 "A Comparison of Different Measures of Risk-adjusted Return".
 What is a good Sharpe Ratio? - Some example calculations of Sharpe ratios
 Sharpe ratio in MS excel - Risk adjusted return calculations
 Calculating and Interpreting Sharpe Ratios online - Cloud calculator