Hedge Fund Reader : The Not So Sharpe Ratio

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July 23, 2006

The Not So Sharpe Ratio

Investors are finding errors and discrepancies in the Sharpe ratio that hedge funds use to project their performance levels. The ratio is a measure of risk-adjusted return and calculates the difference between returns and a risk-free interest rate (generally the yield on US Treasury bills divided by the volatility or range of possible returns).

Nassim Nicholas Taleb, a hedge fund investor and a professor in the sciences of uncertainty at the University of Massachusetts Amherst, has propounded a set of arguments against the effectiveness of the Sharpe ratio:

Its volatility part is not a good measure of risk.
It assumes that economics and finance are solid sciences that permit the usage of statistical tools like the law of averages and the normal distribution in order to model returns.
It cannot be applied to socioeconomic variables like stock market returns where large or small losses and gains have a significant impact on the industry, unlike in a normal distribution where most results fall within a small range on either side of the mean, and a large anomaly or exception will not change the average unless it continues to dominate the sample even when the sample size increases.

Taleb’s conclusion is that the ratio is “like a horoscope – a bogus theory on which most people rely.”

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July 23, 2006 in Gossip & Scandal | Permalink