Sharpe ratio measures the above risk free performance of investment portfolio in relation to its risk. This ratio was developed by William F. Sharpe which introduced the ratio in 1966. Now Sharpe ratio is the most popular ratio when results of mutual investment funds are compared.
The aim of a Sharpe ratio is to compare net investment return (return above risk free interest rate) of a portfolio to the risk of that portfolio. Higher Sharpe ratio means that investment portfolio is more attractive. However, good Sharpe ratio cannot be the only reason to invest in a fund: in reality Sharpe ratio is very dependable on timing. To measure investment portfolio performance any investor should spend some time on benchmark analysis.
Main Problems in Practice
The main problem of practical implementation of this ratio is that theoretically this formula considers ‘expected return of portfolio’ but in reality there are no chances to predict the return of investment portfolio (if it would be possible, investing would be much easier), so expected return in practice is switched to ‘historical average return’; however, the historical evidence shows that there is no real relation between historical returns and future returns, unless we are considering very long periods (decades) but investment markets are changing too fast to use such old data.
Another main problem of this ratio in practice is a period of data. Mostly, last 36 months data are used to calculate the ratio. But the problem is that such period is much too short to make any conclusions about the quality of the portfolio. Of course, it is a practical decision because the main condition is that when Sharpe ratio is compared to ratios of other portfolios, it is necessary that the data period would coincide. And if period would be very long, it would get problematic, because there aren’t so many of old funds that could be compared (mutual fund industry is build in the way to close-up bad performing funds and open-up new ones consistently by promoting those which are successful in that period, even if shortly; another problem is that investment managers are also switched from time to time and in the reality the job of the manager is measured but not the performance of the fund ‘name’, and if new portfolio manager comes, you can forget old results and treat it as a new fund).
However, to get really fair results on the performance of the portfolio, it should include at least one full economical cycle. Of course, it is very problematic in practice, but it is better not to use this ratio at all than to use it for too short period because it will only mislead. The behavior of the financial market is consistently changing under the conditions of intensified globalization and computerization, and the full volatility of a portfolio cannot be noticed during short-mid period. Also if you will compare Sharpe ratio for portfolios of different asset structure and risk using short period data, the results will be meaningless because during bear market Sharpe ratio of risky portfolio will be negative when some money market fund may have slightly positive result but it does not mean at all that the latter one is managed any better.
Other investment performance ratios
Another very similar ratio is Sortino ratio which only calculates standard deviation differently. Other ratios that measures investment performance are Treynor ratio and Jensen’s alpha. Those two might be more accurate but are more difficult to calculate and face even more problems in real practice.
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