Researchers to hedge fund investors: Don’t throw away Sharpe ratios just yet
| Sep 14th, 2008 | Filed under: Academic Research, Performance, Analytics & Metrics, Today's Post | By: Alpha Male |
|
Granted, it took a future Nobel Laureate to invent the Sharpe ratio. Yet this handy measure has achieved unprecedented ubiquity largely because of its simplicity and ease of use, not necessarily its robustness.
The Sharpe ratio assumes that returns are symmetrical and bell-shaped – that the chance of winning is the same as the chance of losing and that these chances are easily predictable if you know the standard deviation. But since hedge funds tend to invest in things that have asymmetrical returns (options, for example), their own returns are often skewed to the positive or negative. Furthermore, these exotic instruments tend to increase the chances of both winning and losing even though the standard deviation of the fund may not change at all.
Given this, you’d think that better measures of hedge fund performance exist somewhere out there. In fact, we’ve written about several candidates on these pages. But a study by Martin Eling of the University of St. Gallen and Frank Schuhmacher of the University of Applied Sciences and Technology Aachen suggests that such a search might actually be in vain. In fact, the duo say the choice of performance measure doesn’t actually influence the relative ranking of hedge funds much at all. (They extend their research into the world of mutual funds in the May/June 2008 issue of the Financial Analysts Journal.)
To continue reading this article please login (at the right) or click here to learn more about accessing our archives.
Related Posts
- Debate over value of Sharpe Ratio in HF analysis continues in new academic study
- Researchers try to fix “unreliable” hedge fund measures
- Alternative Viewpoints: Using the Modified Sharpe & Information Ratios
- Lintner Redux: Omega Ratios and Managed Futures
- Japanese researchers argue there are many ways to skin a kat when it comes to hedge fund cloning
While the methodology is straightforward, it is flawed. It measures merely the statistical tendency for high-ranking Sharpes to also rank highly on Sortino, etc.
A histogram of how many funds changed rankings, and by how much, would be a better metric.
For example, of the 1000s of funds, rank them by deciles using Sharpe. What percentage of funds changed decile categorization by no deciles, one decile, two deciles, etc., when re-ranked by each other metric?
Of course, from the POV of a potential investor trying to determine whether Fund A is better than Fund B, no such “average-based” methodology provides help.
If one has a minimum acceptable return, then one needs to use an evaluation metric that incorporates the minimum acceptable return. It really is as simple as that …