Sharpe Ratio Deep Dive - Is Bigger Always Better?
Comparing one investing strategy or fund against another is complicated. I think most people agree with that. Yet, time and again, we find people using simple but non-objective yardsticks for comparison. As an example, someone may compare one strategy against another based solely on the returns they deliver regardless of what they invest in or the risks involved. Perhaps because it is easier and more convenient this way. Well, this preference for simplicity, whether right or wrong, is here to stay. To somewhat address this, the fund industry introduced a range of risk-adjusted measures. These measures attempt to level the playing ground by giving us the return per unit risk of a fund for a fairer comparison. And the most widely used risk-adjusted measure is undisputedly the Sharpe Ratio developed by William F. Sharpe.
Sharpe Ratio is immensely popular to the extent that “What is your Sharpe?” became a commonly asked question in the industry. I also received a couple of queries on Quora about Sharpe ratios before e.g. Is a high Sharpe possible, and can it be fudged, etc. But realistically speaking, can a single number tell us everything? We wish things were that simple but common sense tells us that this is not possible. Sharpe ratio is useful. There is no doubt about that. But like any other metric, it is just a small part of the whole picture and is not meant to replace full due diligence.
What is Sharpe Ratio?
Sharpe ratio is the de facto risk-adjusted measure adopted by the industry today. What it measures is the excess return a strategy or fund makes over the risk-free rate divided by the volatility of the returns. This effectively gives you the fund’s returns per unit volatility.
As you can see, it makes comparisons more equitable by applying a common risk denominator. So in order to get a high Sharpe ratio, you need a good excess return relative to volatility. If everything else is the same between the 2 strategies or funds, other than their Sharpe, then we can say that the one with the higher Sharpe is superior. But things are never as straightforward because strategies and funds are often hardly the same.
High Sharpe Ratio = Good?
Since Sharpe Ratio measures how effective a strategy or fund is at squeezing out returns per unit risk, then does that mean a high Sharpe ratio translates to good performance? That is not always the case. We need to understand more about what goes behind this number. So before you get impressed by any strategies or funds with a high Sharpe ratio, you might want to look at a few more things.
1. How long is the fund in operation?
Sharpe ratio is just another statistic. If we want to take it seriously, it has to be built on a good sample size. It is fairly easy for strategies or funds with a short operating history, like a couple of months, to achieve a Sharpe of 2 or much higher. All you need is a few good consecutive months of positive returns that are relatively close to each other. See an example below.
In this hypothetical illustration, the strategy or fund manages to deliver an amazing Sharp of 26.7. These are numbers that would make even the veterans' jaws drop if valid. But in this instance, the history is way too short for any of the numbers to be statistically valid. It is still a big question mark whether it can sustain the performance going forward. So in practice, we wouldn't be too fixated on the Sharpe here.
2. What is the granularity used to calculate the Sharpe Ratio?
Most funds report performance by the month. This means we have no idea how the fund did intra-month. It is absolutely possible, whether coincidental or not, that the calmness of the month-to-month moves masked wild intra-month swings that would drive up the volatility dramatically. Let’s use back the same example earlier where the fund delivers a super high Sharpe of 26.72 based on monthly returns. Now, what if we increase the resolution to weekly and the return series looks like this.
In this illustration, I assume each month has exactly 4 weeks. Technically, there are 52 weeks a year and each month is slightly longer than 4 weeks. But let’s put that aside and focus on the change in volatility instead. It swelled from a meager 0.41% to a humongous 51.22%. And needless to say, the high Sharpe now plunges to a miserable 0.21. In order to convey the idea, I made the example kind of extreme. But having said that, a few sharp moves intra-month can cause a material difference in the Sharpe ratio. So the granularity of the data used to calculate Sharpe does matter.
3. Did the period of operation gel with a market state that is favorable for the fund?
Each strategy or fund has its own strengths. They thrive under different market conditions. So contrary to what many think, holy grail strategies don't exist. There is only such a thing called the right strategy at the right time.
What happens when say a fund starts in a period of favorable market state? Obviously, it excels. If it does not, then it should not be in business. For example, if you launched a long-only equity fund in 2017, you are going to do very well. In fact, a fund that does nothing other than replicating the S&P 500 index would have gotten an astounding Sharpe of more than 5 in that year. And to put things in a longer-term perspective, the Sharpe ratio of S&P 500 hovers above 1.5 from 2012 to 2017. This is considered high for stocks. But all these amount to nothing until we see how the fund weathers a downturn. Because if all the fund does is follow the S&P 500, then all we need is a bear market to bring its Sharpe back down to Earth.
4. What is the underlying strategy?
Sharpe is an outcome. It doesn’t tell you anything about the underlying strategy such as what drives its returns and what are its pitfalls. Every strategy is vulnerable to its own tail events, and some are nastier than others. For instance, a trend strategy is extremely susceptible to whipsaws by a volatile market. On the other hand, a mean reversion strategy fears getting on the wrong side of a strong trending market. Even a market-neutral strategy can go awry when both its longs and shorts diverged. And the use of leverage and concentration further magnifies losses during times of stress.
An example is the short volatility trade based on the now delisted inverse VIX ETN - XIV. Now, shorting volatility is immensely popular even among retail traders then because of its profitability. From Jan 2011 to Jan 2018, XIV returned 39.4% on an annualized basis. In particular, during the final 2 years from Jan 2016 – Jan 2018, XIV performed spectacularly, quadrupling over the period with a Sharpe above 2. But without proper risk management and strategy, shorting volatility is akin to holding a time bomb in your hand. If you have no strategy to let go, it can explode. Everything comes to an abrupt end on 5 Feb 2018. VIX surged over 100% as the market turned volatile triggering an unprecedented market squeeze as short volatility ETNs race to cover their shorts. And the end result? XIV collapsed, trading more than 90% below its prior close.
An understanding of the strategy would alert you to a higher probability of catastrophic losses with such strategies despite the high Sharpe. They are essentially selling insurance on such events. When nothing happens, they pocket the premiums. But when something happens, they are out of the game.
Use Sharpe to Complement Not Replace A Full Due Diligence
Sharpe is not a standalone performance metric. On top of that, you need to consider the context of how we arrive at a strategy or fund's Sharpe. It would be naive to think that a single number is all you need. Instead, it should be used to complement a broader analysis. There are many more ways you can dissect and look at a strategy or fund. Comprehensive due diligence is never complete without studying the investment philosophy, objective, strategy concept, strengths and weaknesses, risk management methodologies, peer analysis, and performance over different cycles, etc.
IBF Accredited Course
Introduction to Quantitative Investing & Hedge Fund Strategies
AllQuant is a financial education provider. For those who are interested in learning more about how to use a quantitative approach to build a resilient multi-strategy portfolio, we run a skills-future eligible 3-day live online course via Zoom which is heavily subsidized (up to 90%*) and accredited by the Institute of Banking and Finance.
You can find out more below.
* IBF Subsidy will be reduced after 30 June 2022