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, Nobel laureate William Sharpe, has admitted the ratio is not without its problems. (See also: 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. (See also: Option Spread Strategies.)
For example, according to Hal Lux in his 2002 Institutional Investor article "Risk Gets Riskier," Long-Term Capital Management (LTCM) had a very high Sharpe ratio of 4.35 before it imploded in 1998. Just as 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. (See also: 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 2001 article "Warning: Danger Hidden In Those Hedges," 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.
A Better Mousetrap
So is there an easier answer to measuring risk and return?
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. (See also: The Uses And Limits of Volatility and Understanding Volatility Measurements.)
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 Alternative Investment Research Center at the Cass Business School in London, said, "Risk is one word, but it is not one number."