When looking to invest, you need to look at both risk and return. While return can be easily quantified, risk cannot. Today, standard deviation is the most commonly referenced risk measure, while the Sharpe ratio is the most commonly used risk/return measure. The Sharpe ratio has been around since 1966, but its life has not passed without controversy. Even its founder, William Sharpe, has admitted the ratio is not without its problems.

Tutorial: Risk And Diversification

The Sharpe ratio is a good measure of risk for large, diversified, liquid investments, but for others, such as hedge funds, it can only be used as one of a number of risk/return measures.

Where It Fails
The problem with the Sharpe ratio is that it is accentuated by investments that don't have a normal distribution of returns. The best example of this is hedge funds. Many of them use dynamic trading strategies and options that give way to skewness and kurtosis in their distribution of returns.

Many hedge fund strategies produce small positive returns with the occasional large negative return. For instance, a simple strategy of selling deep out-of-the-money options tends to collect small premiums and pay out nothing until the "big one" hits. Until a big loss takes place, this strategy would show a very high Sharpe ratio. (For more insight, read Option Spread Strategies.)

For example, according to Hal Lux in his article, "Risk Gets Riskier", which appeared in Institutional Investor in 2002, Long-Term Capital Management (LTCM) had a very high Sharpe ratio of 4.35 before it imploded in 1998. Just like in nature, the investment world is not immune to long-term disaster, for example, like a 100-year flood. If it weren't for these kinds of events, no one would invest in anything but equities.

Hedge funds that are illiquid, and many of them are, also appear to be less volatile, which conveniently helps their Sharpe ratios. Examples of this would include funds based on such broad categories as real estate or private equity, or more esoteric areas like subordinated issues of mortgage-backed securities or catastrophe bonds. With no liquid markets for many securities in the hedge fund universe, fund managers have a conflict of interest when pricing their securities. The Sharpe ratio has no way of measuring illiquidity, which works in fund managers' favor. (Learn about some of the biggest fund failures, in Massive Hedge Fund Failures.)

Volatility also tends to come in lumps - in other words, volatility tends to breed volatility. Think back to the LTCM collapse or the Russian debt crisis in the late '90s. High volatility stayed with the markets for some time after those events took place. According to Joel Chernoff in his article, "Warning: Danger Hidden In Those Hedges" (2001), major volatility events tend to occur every four years.

Serial correlation can also overstate a Sharpe ratio when present in month-to-month returns. According to Andrew Lo in "The Statistics of Sharpe Ratios" (2002), this effect can cause the ratio to be overstated by up to 65%. This is because serial correlation tends to have a smoothing effect on the ratio.

Furthermore, thousands of hedge funds have not even been through a complete business cycle. For those that have, many have experienced a change of managers or a change in strategies. This shouldn't be a surprise, as the hedge fund industry is one of the most dynamic in the investment world. However, that doesn't give the investing public much comfort when their favorite hedge fund, which is sporting a nice Sharpe ratio, suddenly blows up one day. Even if the manager and strategy remain the same, the size of the fund could change everything - what worked so well when a hedge fund was $50 million in size might be its curse at $500 million.

So is there an easier answer to measuring risk and return?

A Better Mousetrap
While the Sharpe ratio is the most famous risk/return measure, others have been developed. The Sortino ratio is one of them. It is similar to the Sharpe ratio, but its denominator focuses solely on the downside volatility, which is the volatility that concerns most investors. Market neutral funds claim to be able to give their investors all the upside, but limited downside. If that is the case, the Sortino ratio would help them validate that claim. Unfortunately, while the Sortino ratio is more focused than the Sharpe ratio, it shares some of the same problems. (For related reading, see The Uses And Limits Of Volatility and Understanding Volatility Measurements.)

Conclusion
It's clear that the Sharpe Ratio can be one of your risk/return measurements. It certainly will work better for an investment that is liquid and has normally distributed returns, such as the S&P 500 Spiders. However, when it comes to hedge funds, you need more than one measure. For example, Morningstar now uses a number of measurements: skewness, kurtosis, Sortino ratio, positive months, negative months, worst month and maximum drawdown. With this kind of information, an investor can get a better picture of an investment and what to expect for the future.

Remember, as Harry Kat, professor of risk management and director of the AlternativeInvestmentResearchCenter at the CassBusinessSchool in London, said, "Risk is one word, but it is not one number."

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Nasdaq Biotechnology

    Find out information about the ProShares Ultra Nasdaq Biotechnology exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  2. Fundamental Analysis

    Examining Mexico's Trillion-Dollar GDP

    Examining the gross domestic product growth and composition of Mexico, the second largest economy in Latin America
  3. Mutual Funds & ETFs

    ETF Analysis: iShares Floating Rate Bond

    Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates.
  4. Mutual Funds & ETFs

    Top 5 Japan Mutual Funds

    Discover five of the most popular and best-performing mutual funds offering investors direct exposure to equities of Japanese companies.
  5. Fundamental Analysis

    What Causes Inflation in the United States

    Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out.
  6. Term

    What is a Prime Brokerage?

    A prime brokerage offers special services to certain clients.
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  8. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  9. Mutual Funds & ETFs

    5 Mutual Funds that Hold Berkshire Hathaway Stock

    Discover the top five mutual funds most heavily weighted with Berkshire Hathaway stock, and the percentage of their assets dedicated to BRK.
  10. Mutual Funds & ETFs

    3 Mutual Funds that Hold Google Stock

    Discover the top three mutual funds that dedicate the largest percentage of their total assets to Google, Inc. stock.
RELATED TERMS
  1. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s ...
  3. Supply

    A fundamental economic concept that describes the total amount ...
  4. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  5. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
RELATED FAQS
  1. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  2. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  3. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. What percentage of a diversified portfolio should large cap stocks comprise?

    The percentage of a diversified investment portfolio that should consist of large-cap stocks depends on an individual investor's ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!