Jan

31

Q&A About the Sharpe Ratio

January 31, 2008 | Leave a Comment

Q: I am wondering if any of you sharp minds out there can help me understand the Sharp ratio.     In order to achieve a high Sharp ratio, doesn’t one have to have high cash levels at all time?   

A: This explanation is offered by site visitor Trevor:   

In my opinion a high, and consistent, Sharpe ratio is dependent on a successful and consistent return stream. That’s what it’s trying to measure: the returns over the risk-free rate divided by the volatility/Standard Deviation of those returns.

In my view that is generated by a strategy that possesses the following: a high success ratio, a positive and wide spread between largest gain and loss, and a positive and wide spread between average gain and average loss. A strategy that has a good success ratio, but it’s losses tend to be disproportionate with it’s gains, will not have a high Sharpe ratio over long periods of time. It may be that if you use or invest in the strategy during on of it’s “hot streaks” you will make money, but once a few of those losses occur, and they will, that Sharpe ratio will drop very quickly. But obviously having just a positive spread between losses and gains is not enough.

The success of the overall strategy is important. Having a strategy with a success ratio of 40%, even with a positive spread between gains and losses of say 0.50%, will generate consistent, but also very tepid, returns. So if the volatility “perks up” and/or the strategy goes through one of it’s “poor periods” you may have a small and even negative Sharpe ratio.    

All in all, in my view the best way to create a high, and consistent, Sharpe ratio is to devise a strategy that generates positive spreads with a greater than 50% chance of success. It’s simple gambling. Would you rather wager on an event where the odds are skewed in your favor, and you make more money on your victories? Or would you bet on a strategy where the odds are against you, and you lose more money when you lose the bet?    

Holding lots of cash only promises that you make risk-free rates on that portion of your portfolio: to generate the alpha needed, you will still need to find a consistent (read: low volatility) and profitable strategy. And I wouldn’t mention that you were holding large amounts of cash: because although you can use tactics like Optimal F, nobody is going to pay 1/20 for money market returns. Hope this helps, Trevor.   

Another perspective is offered by an HFC site visitor, Bud Bundy:   

The Sharpe Ratio recognizes the following: that leveraging an investment to magnify gains (and losses) does NOT make it a better investment. This is because risk is proportionately increased when you do so. Any investment’s Sharpe Ratio is calculated to be the same, regardless of how much leverage you use.    

For example, assume that you invest in a mutual fund that has a return of 12% and a volatility of 10%. Also, assume that the “risk-free” rate is 5%. The Sharpe Ratio is equal to (15% - 5%)/10%, or 0.70. If you decide to leverage this mutual fund by buying twice as much using margin, you can expect the following: a return of 24% with a margin cost of 5% for a net return of 19% and a volatility of 20%. The Sharpe Ratio, then, is equal to (19% - 5%)/20%, or the same 0.70.     So to really improve the QUALITY of your portfolio instead of just magnifying gains and losses, look to improve your Sharpe Ratio.


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