Sharpe ratio: positives, negatives and alternative

05 Jun 2014

Sharpe ratio, defined as the ratio of the mean return in excess of the risk free rate over its standard deviation. It rests on the hypothesis that returns are normally distributed and/or that the investor has a utility function whose only arguments are expectation and  variance of returns. 

Positive side of Sharpe ratio
•    Simplicity and ease of interpretation are the main strength
•    Still widely used by financial institutions to compare the performance of funds
•    It cannot be manipulated by leverage – which is a weakness of Jensen’s alpha measurement

Negative side of Sharpe ratio
•    It does not quantify the value added, if any: it is only a ranking criterion
•    Assumes frictionless financial markets, so that it is possible to borrow to invest more than 100% in a risky portfolio – and this is not always possible
•    The risk free rate is constant and identical for lending and borrowing
•    The Sharpe ratio is an absolute measure that does not refer to a benchmark

Investors investment horizon must match the performance measurement period. Also as it measures the total risk, Sharpe ratio is only suitable for investors who invest in only one fund. In case of aggregation of portfolios, its consolidation is not straightforward because of the covariance effects between volatilities.

Alternative to Sharpe ratio
CUBI thinks that to Sharpe ratio a good alternative is Ulcer index. Why? It is computed as the quadratic mean of the percentage drops in value during the observed period. It measures the depth and the duration of percentage drawdowns in price from earlier highs. Ulcer have couple of advantages compared to Sharpe ratio.  It considers only downward changes and the strings of losses that result in significant drawdowns in value are recognized.

Bottom line: Despite the fact that Sharpe ratio is simply, widely used measurement, it has more negative aspects than positive ones. According to CUBI, Ulcer index could be an alternative for more positive aspects.

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