Sharpe ratio
What is Sharpe and why does it matter?
Quick Definition
Sharpe ratio is a performance metric commonly used to assess hedge funds and can be roughly though of as "risk-adjusted investment performance," although that is a relatively simple definition. Generally speaking, a Sharpe ratio above 1 means that there some amount of reward in excess of risk taken to achieve that reward, and the higher the Sharpe ratio the better - again, generally. Any fund manager hoping to raise capital from allocators should be capable of calculating and understanding their Sharpe ratio.
Sharpe basics: Comparing two strategies with similar returns
Imagine that you are presented with two strategies that each achieved a twenty percent return over a given period – which is better? Absolute return % is not useful in this context, but surely one of these strategies is likely preferable to the other, and as such, different performance metrics, such as Sharpe, can be utilized.
As an extreme example, imagine if one of the two strategies advanced strictly linearly from 0% to 20% over the period in question. We’ll call it “Strategy C,” as in consistent. On the other hand, imagine if the other strategy swung wildly up and down over the time period – we’ll call this second strategy “Strategy V,” as in volatile.
It should be fairly obvious that many allocators and investors would prefer Strategy C. While Strategy V might have some higher upside, that upside is offset by its downside risk, and continuing to hold Strategy V will certainly be more challenging. Additionally, where exactly Strategy V will be and what it will return on a forward looking basis is hard to forsee, whereas Strategy C seems much more predictable. Lastly, even if over a long period of time Strategy V and C tend to converge, it is hard to predict if and when Strategy V will do so, and it is much more likely that Strategy V provides less opportune liquidity, as an investor may wish to withdraw during a downswing.
In summary, Strategy V is more or less a riskier strategy relative to reward as compared to Strategy C. Strategy C would have the higher Sharpe than V.
Contextualizing Sharpe numbers
What is a good or bad Sharpe ratio?
For starters, most people will seek to outperform $SPY, so understanding $SPY’s approximate Sharpe is helpful – on a trailing basis of 10-20 years, $SPY’s Sharpe is about 0.5.
This is the baseline that most hedge funds attempt to achieve – otherwise, there is generally very little reason why an investor would choose to invest in a hedge fund over SPY. An acceptable Sharpe ratio would be anything between 0.5 to 1, but a good hedge fund would typically aim to have a Sharpe of 1 to 2. An excellent hedge fund is shooting for 2+ over a significant period of time.
Caveats of Sharpe ratio
Sharpe is arguably best used in a standalone context, but looking at Sharpe and Sharpe only in the context of constructing a portfolio would typically be a mistake. That is because since Sharpe aims largely to measure volatility, two low Sharpe strategies held concurrently might aggregate to a total Sharpe greater than the sum of its parts!
The simplest way to imagine this is just to consider a wiggly line and then pairing it with another wiggly line that is exactly inverted; where the first goes up, the second goes down, and so on. The two lines individually are volatile, but combined, they are perfectly straight – the diversification across two strategies that individually were quite volatile has now led to an extremely non-volatile net portfolio with similar overall returns: a better Sharpe!
Sophisticated allocators, then, evaluate Sharpe in a broader context than simply its face-value number, and a low Sharpe can actually be a boost to an allocators overall portfolio construction depending on the other strategies and investments held by that portfolio. Similarly, a high Sharpe is not always as good as it seems.
