Wednesday, July 15, 2009

Negative Sharpe ratios

In our newsletter I've commented on the perceived problem with negative Sharpe ratios: that the results appear to be counter intuitive. When excess returns are positive, if the portfolio did a better job of managing risk, it will show a higher Sharpe ratio; however, when returns are negative, the inverse occurs. While some find no problem at all with this, others are challenged by these results.

Craig Israelsen has written a couple of articles on this topic and, at our request and urging, provided one for The Journal of Performance Measurement, and will appear in our upcoming (and unfortunately delayed) Summer issue.

Until the last year or so, although this problem was known by many, it didn't seem to be much of an issue because the bull market often meant that the long-term excess returns were positive. However, because of the devastation that was wrought upon the investment community last year, many are seeing negative excess returns and the accompanying oddity with the Sharpe ratio (and, by the way, the Information Ratio, too!).

Space doesn't permit me to go into detail on this topic in one sitting, so I'll return to it again. I encourage you to become familiar with Israelsen's piece, as well as the writings of others who have chimed in on this subject.

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