Module I·Article VI·~2 min read
Sharpe Ratio
Portfolio Thinking and Governance Framework
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Sharpe Ratio
The Sharpe Ratio: the gold standard developed by William Sharpe (Nobel laureate 1990), is the most common indicator of investment performance that accounts for risk. It answers the question: “How much additional return do we get for each unit of risk taken?” Formula Sharpe Ratio = (Rp - Rf) / σp Rp — portfolio return Rf — risk-free rate (usually T-Bills yield) σp — volatility (standard deviation) of the portfolio (Rp - Rf) — excess return (risk premium)
Interpretation of Sharpe Ratio Values
| Evaluation | Comment |
|---|---|
| Poor | A risk-free asset is better |
| 0 - 0.5 | Weak |
| 0.5 - 1.0 | Acceptable |
| 1.0 - 2.0 | Good |
| 2.0 - 3.0 | Excellent |
| > 3.0 | Suspicious |
Practical Example
Risk-free rate Rf = 4%. Comparing three funds:
| Fund | Return | Volatility | Sharpe | Conclusion |
|---|---|---|---|---|
| “Conservative” | 8% | 5% | 0.80 | Best risk-adjusted return |
| “Balanced” | 12% | 12% | 0.67 | Average efficiency |
| “Aggressive” | 18% | 25% | 0.56 | Lots of risk, little premium |
Paradox: The “Conservative” fund with an 8% return is more efficient than the “Aggressive” one with 18%!
Sharpe Ratio of Well-Known Strategies
| Strategy/Asset | Historical Sharpe |
|---|---|
| S&P 500 (long term) | 0.4 - 0.5 |
| Warren Buffett (Berkshire) | 0.76 |
| Renaissance Medallion Fund | ~2.0+ (legendary) |
| Hedge Funds (median) | 0.3 - 0.5 |
| 60/40 Portfolio | 0.5 - 0.6 |
| Risk Parity (Bridgewater) | 0.6 - 0.8 |
Limitations of the Sharpe Ratio
- Symmetrical volatility — does not distinguish between upside and downside risk
- Normal distribution assumption — underestimates risk for fat-tailed strategies
- Manipulability — Sharpe can be “improved” via leverage or selling options (hidden risks)
- Time period dependence — 3-year Sharpe can differ greatly from 10-year
- Choice of Rf — which rate to use? T-Bills? SOFR? Depends on currency and time period
Sharpe Ratio Modifications
| Indicator | Formula | When to Use |
|---|---|---|
| Information Ratio | (Rp - Rb) / TE | Relative to benchmark, not Rf |
| Sortino Ratio | (Rp - Rf) / σd | Downside risk only |
| Calmar Ratio | Rp / Max Drawdown | For hedge funds |
| Omega Ratio | Gains / Losses | Does not assume normality |
Practical Use for the CIO
- Comparing managers — all else equal, choose the one with the highest Sharpe
- Portfolio optimization — maximizing Sharpe = efficient frontier
- Monitoring — a drop in Sharpe signals problems
- Reporting — standard metric for investors
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