Alternative Viewpoints: Due to funds’ lack of persistence, the Sharpe ratio has no validity as an investment decision tool
Oct 29th, 2009 | Filed under: CAIA Alternative Viewpoints Columns, Guest Posts, Today's PostThere have been many studies on hedge fund manager return “persistence”. Persistence, after all, is a necessary precondition for the existence of alpha. Like alpha itself, you might expect that the persistence of a good Sharpe ratio may be possible in less mature (more informationally inefficient) markets. But a new study by Siewling Lay, CAIA, finds that this intuition might be wrong.
Special to AllAboutAlpha.com by: SiewLing Lay, CAIA, senior analyst, GFIA
Many investors use the Sharpe ratio conveniently to categorize the risk-adjusted return profile of a hedge fund. Implicit in its use is the assumption that the fund’s Sharpe ratio is somehow persistent over time – that a good fund manager will stay “good”. As a result, many investors look to the Sharpe ratio as an indication of how a manager might perform in the future. If investors decide to include it in their assessments of a fund’s attractiveness for investment, its persistence and reliability would clearly be important.
You might expect that good managers are able to persist in less efficient markets such as emerging markets. To explore this, my GFIA colleagues and I tested whether in fact Sharpe ratios of Asian hedge funds persisted on a multi-year time frame. What we discovered might come as a surprise.
Firstly, to ensure that no single fund benefitted from a certain market environment, we examined hedge fund performance over a common timeframe: July 2007 to July 2009 (i.e. not since the inception of each fund).
As you can see from the table below from our report, funds that fall below the 25th percentile show little consistency on a year on year basis. In fact, only 28% of funds in the top quartile in 2007 actually remained there in 2008: More…
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We find similar results in this study http://www.infiniti-analytics.com/kb/kb/article/infinitisfascorearapm
Interestingly we find that the Sortino ratio does worse than expected due to the fact that, because of the high quality of the 36 underlying funds, it is possible for the computer to find a set of weights that gives an in in-sample portfolio with no downside deviation. When we repeat the study using Indices instead of individual funds the Sortino ratio out-performs the Sharpe ratio.
Nice post. Yes, the Sharpe Ratio is not at all stable. Dr. Galen Burghardt et al, also proved this in a paper (http://www.intercontilimited.com/mfutsarchive/correlation_duration.pdf). It’s reckless and not prudent to use the Sharpe Ratio as an important metric given that it’s not stable, doesn’t take into account the higher statistical moments, that it can be gamed by smoothing for illiquid hedge funds, and that it penalizes for upside volatility.