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.)

More…