William Sharpe's Sharpe ratio is a measure of risk-adjusted returns used to determine the best or worst returns given volatility within a market. The Sharpe ratio measures the ability of a portfolio to perform when volatility is treated as a negative aspect. The formula determines the return an investor receives in exchange on a risk-adjusted basis. When evaluating the return on an asset, the higher the ratio, the better the performance. The Sharpe ratio is widely accepted as a benchmark for determining hedge fund performance and the volatility of returns an investor must accept when investing in a specific portfolio.
Sharpe Ratio Advantages
The Sharpe ratio has its advantage in that it is directly calculated from any observed series of returns without the need for additional information surrounding the source of profitability. The Sharpe ratio observes both systematic and unsystematic risk. Systematic risk is inherent to the entire market or entire market segment, while unsystematic risk is a company or industry specific risk that is inherent in each investment. The returns that are used to calculate the Sharpe ratio are any unit of time measurement, such as daily, weekly or monthly. Stanford University teaches Sharpe ratio calculation by dividing the average return (which subtracts the risk-free rate of return) over a period by the standard deviation of those returns.
Sharpe Ratio Disadvantages
The disadvantages of using the Sharpe ratio pertain to the distribution of some assets that might not be normal. Abnormalities within the distribution can generate outcomes that do not make sense, as the standard deviation of a time series doesn't have the same effectiveness when these distribution issues exist.
Improve the Sharpe Ratio
The Sortino ratio considers the downside risk as the only source of volatility measured by an investor. By definition, the Sortino ratio is closely related to the Sharpe Ratio. The Sortino ratio examines the standard deviation of months where the returns are negative, and ignores creating a standard deviation for positive months. The advantage of this ratio is that it does not penalize a manager for volatility of positive returns.
The information ratio was also created by William Sharpe as an alternative to the Sharpe ratio. While the Sharpe ratio uses volatility as its metric to determine risk adjusted returns, the Information ratio uses a bogey as a benchmark, such as an equity or fixed income index. Using the Information ratio as an alternative to improve the Sharpe Ratio varies the bogey in the sense that it compares risk to another financial instrument as compared to the volatility of the portfolio.
David Becker is a finance writer and consultant in Great Neck, N.Y. With more than 20 years of experience in trading, he runs a consulting business that focuses on energy hedging and capital market analysis. Becker holds a B.A. in economics.