Oct 27, 2008

Sharpe Ratio - Risk Adjusted Return

After reading the "measuring the portfolio performance using risk adjusted measure called Sharpe Ratio" post, you also need to be cautioned about the limitations of Sharpe Ratio. This happens when the Sharpe Ratio is measured for a prior shorter period when a big swing has not happened and the Standard Deviation fails to account for the volatility that is beyond the range of the time window selected.

One of the main drawbacks with Sharpe Ratio is its reliance on Standard Deviation of the Returns are the only form of Risk measured. Standard Deviation is an appropriate risk measure for portfolio strategies with almost symmetric return distributions. The Sharpe Ratio works generally for the market during most times, except when the market swings are too big in one direction.

That is precisely what is happening currently (later half of 2008). For the year 2008 we have seen modest up movements earlier in the year, but the later half has been a debacle. Until mid 2008, the Standard Deviation measured did not include extreme values and hence the risk assumed was not correctly represented. Hence the portfolio Sharpe Ratios could have showing higher values without revealing the volatility hidden in the measurement. With a huge negative swing in the return, the Sharpe Ratio calculated up to the big decline has been misleading. The point being that the extreme negative swing in the market is testing the suitability of using Sharpe Measure for the portfolio performance evaluation.

One way to account for this drawback is to make the time window of portfolio measurement to include a prior big swing, and this can be a very big time window. This may not serve a good purpose for shorter period performance measurement, but at least it can offer a historical perspective for the performance measured!

-Nidhi