The Sharpe ratio is a way to determine the level of return achieved per unit of risk. It is very useful and can be calculated by all forms of capital market participants to gauge their performance, from day traders to long-term buy and hold investors. .
Naturally, when assessing the performance of traders and investors, it is not simply a matter of determining their overall return, but their return relative to their risk.
A 20% annual increase is a very strong performance. However, if this comes from 60% annual volatility due to excessive leverage or trading very speculative instruments, this is actually a relatively moderate performance when adjusted for risk. The Sharpe ratio will be considered as 0.3. This is calculated as follows:
Sharpe Ratio = (Portfolio Return – Risk-Free Return) / Portfolio Std Dev
The risk-free rate of return is a user-based input. This is usually equivalent to a risk-free safety bond . This could be the yield of the US Treasury, the British Gilt, the German package, or another safe-haven instrument. Its duration depends on your time horizon.
For long-term investors or position traders who hold positions for a long time, they can choose bonds with longer maturities. Short-term investors or day traders who can only hold positions during the day can use shorter tráibondterms or almost an equivalent rate to countries’ overnight rates. regulated by its central bank. This is usually approximated by one-month or three-month government bonds or just by looking at the central bank’s overnight interest rate policy.
In the case of the 20%/60% increase in volatility mentioned above, if one were to use 10-year US Treasuries (assuming a 3% yield), the Sharpe ratio would be 0.283. If one were to use 3-month US Treasuries (assuming 2% yield), the Sharpe rate would go up to 0.300.
If a higher risk-free rate is used, this means a lower Google excess return – namely a 17% return compared to a less than equal risk-free rate. reimbursement in excess of 18%. Therefore, a higher risk-free rate will result in a lower Sharpe ratio, keeping all other ratios equal.
Ratio of Ex-Ante to Ex-Post Sharpe
The Sharpe ratio can be thought of as ex-ante (expected) or ex-post (looking backward to gauge past performance).
The rate considered above is the old post in which its performance happened. Sharpe ex-ante ratio takes expectations into account. Instead of portfolio returns and volatility, the calculation is instead the expected values of those, represented by (E) before the terms.
Sharpe Ratio = E (Portfolio Return – Risk-Free Return) / E (Portfolio Std Dev)
Thus, if the S&P 500 is expected to generate 7% nominal annualized returns, reduce annual volatility by 15%, with a risk-free rate of return of 3% (based on US Treasury yields). in the future), that produces a Sharpe ratio of 0.27.
The old hand rate can be very different, especially on shorter time frames. For example, the S&P 500’s Sharpe ratio for 2017, due to higher returns at low volatility, is 4.78. For this year’s portion of 2018, it’s already 0.23.
Applications in finance
The Sharpe ratio is commonly used to determine the relative performance of portfolios, traders, and fund managers over time. Sharpe ratios for individual asset classes are typically between 0.2 and 0.3 over the long term.
A value between 0 and 1 indicates that the returns are better than the risk-free rate, but the excess risk exceeds their excess return. A value above 1 indicates that the return is not only better than the risk-free rate, but that the return exceeds the excess risk.
A negative Sharpe ratio means a manager or portfolio’s performance is lower than the risk-free ratio. For financial assets, a negative Sharpe ratio will not last for an indefinite period. Capitalist economies will stop working if this is true.
Negative Sharpe ratios can persist over the long term for specific asset classes, managers, or portfolios due to the time or individual risk involved in trading certain assets.
However, negative Sharpe ratios are difficult to assess because negative excess returns with large volatility will actually cause Sharpe ratios to decrease (because of larger denominators), thus asserting that performance Its not as bad as expected. Likewise, a portfolio with a small negative excess return can be punished if the volatility associated with it is large, creating a smaller denominator and thus amplifying the negative value.
Therefore, a negative Sharpe ratio can be extremely difficult to assess.
Pros and cons of Sharpe . ratio
Like any statistical measure, it is only as good as its assumptions. In studies of financial risk assessment, it is often assumed that volatility equates to risk or is its best proxy. However, not all volatility is harmful and some are absolutely necessary to catch back.
Trading and investing is essentially about maximizing profit per unit of risk. This is the central intention of the Sharpe ratio, but it does it in a simple way.
Trading or investment strategies that properly balance risk or can accurately identify powerful risk-reward opportunities will have increased volatility. But considering that all volatility is penalized equally by the Sharpe ratio, the metric may not be the best for accurately determining the risks associated with a portfolio.
Other risk-adjusted metrics, such as the Sortino ratio, may be more suitable for these types of portfolios and will often more accurately reflect their risk.
However, the Sharpe ratio is easily applicable and can be applied to any profit series without additional information regarding the sources of volatility or returns.
The volatility of returns is also assumed to be normally distributed. Typically, financial variables tend to be fatter than those associated with a normal distribution and often exhibit higher skewness and/or kurtosis.
And because the Sharpe ratio is often used in the old sense – to gauge past performance – it can be flawed since past performance is not necessarily any predictor of what will happen. in the future or in the short term.
Furthermore, since the Sharpe ratio is not expressed as a percentage or profit, but as a simple number, its use is valid only in comparison to other performances assessed through the Sharpe ratio. .
As a rule of thumb, a Sharpe ratio above 0.5 is superior performance if achieved in the long run. Rate 1 is great and hard to achieve in the long run. A ratio of 0.2-0.3 is suitable for the broader market. A negative Sharpe ratio, as noted above, is difficult to assess.