Scribd Logo
Upload

Welcome to Scribd!

  • 38 views

    Sharpe Ratio

    Uploaded by

    Jithesh Gopidas
    This article discusses different performance evaluation measures for active portfolios, specifically Sharpe ratio and information ratio. [1] Sharpe ratio measures excess returns over the risk-free rate per unit of volatility but has limitations when comparing across funds that use different definitions of risk-free rate. [2] Information ratio compares the excess return of a fund over its benchmark per unit of volatility, providing a better measure of whether an active investment decision was worthwhile. [3] A higher information ratio indicates the portfolio manager is generating more excess returns relative to the benchmark per unit of risk taken on.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOCX, PDF, TXT or read online from Scribd

    Sharpe Ratio

    Uploaded by

    Jithesh Gopidas
    38 views2 pages
    This article discusses different performance evaluation measures for active portfolios, specifically Sharpe ratio and information ratio. [1] Sharpe ratio measures excess returns over the risk-free rate per unit of volatility but has limitations when comparing across funds that use different definitions of risk-free rate. [2] Information ratio compares the excess return of a fund over its benchmark per unit of volatility, providing a better measure of whether an active investment decision was worthwhile. [3] A higher information ratio indicates the portfolio manager is generating more excess returns relative to the benchmark per unit of risk taken on.

    Copyright

    © Attribution Non-Commercial (BY-NC)

    Available Formats

    DOCX, PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    This article discusses different performance evaluation measures for active portfolios, specifically Sharpe ratio and information ratio. [1] Sharpe ratio measures excess returns over the risk-free rate per unit of volatility but has limitations when comparing across funds that use different definitions of risk-free rate. [2] Information ratio compares the excess return of a fund over its benchmark per unit of volatility, providing a better measure of whether an active investment decision was worthwhile. [3] A higher information ratio indicates the portfolio manager is generating more excess returns relative to the benchmark per unit of risk taken on.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    38 views2 pages

    Sharpe Ratio

    Uploaded by

    Jithesh Gopidas
    This article discusses different performance evaluation measures for active portfolios, specifically Sharpe ratio and information ratio. [1] Sharpe ratio measures excess returns over the risk-free rate per unit of volatility but has limitations when comparing across funds that use different definitions of risk-free rate. [2] Information ratio compares the excess return of a fund over its benchmark per unit of volatility, providing a better measure of whether an active investment decision was worthwhile. [3] A higher information ratio indicates the portfolio manager is generating more excess returns relative to the benchmark per unit of risk taken on.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 2

    Sharpe ratio: Good performance measure for active portfolios?

    B. Venkatesh

    The column dated October 11, 2009 discussed why retail investors should not use manager universe benchmarks to “fire” portfolio
    managers. In response to that article, one reader asked the following question: Can investors use Sharpe ratio, a risk-return metric
    provided by asset management firms in their monthly newsletter, as a performance evaluation measure?

    This article discusses Sharpe ratio. It then shows why this measure may not be optimal to evaluate active portfolios and instead
    suggests another simple measure to assess active returns.

    Sharpe ratio

    Sharpe ratio captures the excess returns that a portfolio manager generates over the risk-free rate per unit of volatility.

    That is, the ratio is computed as average portfolio returns minus risk-free rate divided by standard deviation of the portfolio returns.
    Sharpe ratio is typically used to rank portfolios within the same style universe.

    Suppose an investor has exposure to a mid-cap active fund. She can compare the fund's Sharpe ratio with that of other mid-cap
    active funds to see how well her investment has performed. A higher Sharpe ratio indicates that the portfolio manager is generating
    higher excess returns per unit of volatility.

    Sharpe ratio considers the total risk of a portfolio- systematic and non-systematic risk. But does this ratio enable investors to
    meaningfully analyze the performance of a fund?

    Peer universe evaluation

    Asset management firms typically use the 91-day Treasury Bill as a proxy for risk-free rate. This requires “rolling over” the T-bill rate
    at least four times to compute yearly Sharpe ratio. As there is no standard yet, firms do not all follow the same procedure to define
    and compute the risk-free rate. Comparing funds across the style universe, hence, becomes a problem.

    Importantly, however, Sharpe ratio does not help investors evaluate the decision to take active exposure. Why? In the hierarchy of
    exposure, an investor's first choice is the risk-free asset, as it is the least volatile.

    The next choice is the passive exposure to risky assets such as equity. The choice of active investment follows the passive
    exposure.

    An investor would buy an active fund only if she is convinced that the fund can generate excess returns over the passive
    benchmark. Given this, evaluating the active decision would be meaningful if the portfolio is compared with a passive style
    benchmark instead of the risk-free rate.

    Information ratio

    A “Generalized Sharpe ratio” compares the excess return over the benchmark per unit of volatility of such excess returns. The
    resultant ratio is called as Information ratio.

    Take Franklin India Bluechip Fund, whose benchmark is the BSE Sensex.

    First, the investor has to calculate the return differential between the fund and its benchmark. Annualising monthly returns over the
    last three years is one way of finding the excess returns (or alpha).

    The excess return is then divided by the volatility (standard deviation) of the excess returns for the relevant period to arrive at the
    ratio.

    The information ratio essentially measures active return per incremental unit of risk earned by the portfolio manager by deviating
    from the benchmark's passive portfolio. Performance analysts also use information ratio to find out the probability of the fund losing
    money or beating a benchmark during any year. Suffice it to know that this is possible to measure when alpha is assumed to be
    normally distributed.
    Conclusion

    Investors can use information ratio to see if their decision to take active exposure paid off. Higher the ratio, better the decision.

    Typically, a ratio of 0.50 is considered good. It would be also useful to compare the fund's Information ratio across time to check for
    consistency of alpha returns.

    Information ratio does not, however, help in evaluating whether the portfolio manager has delivered alpha due to luck or skill.

    Besides, the usefulness of the ratio is dependent on the appropriateness of the benchmark selected to capture the manager's
    investment process.

    (The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be
    reached at enhancek@gmail.com)

    Related Stories:
    Don’t fire your manager!
    Employing asset allocation strategies for optimal gains

    More Stories on : Stock Markets | Investments | Micromotives

    Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

    You might also like