Just when you thought it was safe to ...
I'm doing a bit of research on the Sharpe and Information ratios, and am finding loads of confusion. This may end up becoming an article, but for now I'll share with you some "facts," at least as I understand them, regarding the Sharpe ratio.
1. The Sharpe ratio was developed by William F. Sharpe (Sharpe, William F. (1966). "Mutual Fund Performance." Journal of Business), who was awarded the Nobel Prize in Economics.
1a. Sharpe's Nobel was not awarded for this risk measure, but rather for his work on CAPM.
2. Sharpe referred to his measure as "reward to variability," and to Treynor's (which was published in 1965) as the "reward to volatility."
2a. Neither terms seem to have made it into the common lexicon.
3. Sharpe introduced a revised version of his formula in 1994 (Sharpe, William. (1994). "The Sharpe Ratio." Journal of Portfolio Management). It appears, though not yet confirmed, that the earlier version dominates in our industry.
4. Although it appears that many firms use annualized values in their formula, Sharpe (1994) states that "To maximize information content, it is usually desirable to measure risks and returns using fairly short (e.g., monthly) periods. For purposes of standardization it is then desirable to annualize the results."
5. In Sharpe (1994), the author acknowledges how "The literature surrounding the Sharpe Ratio has, unfortunately, led to a certain amount of confusion." For example, he cites an article by Treynor-Black that define the ratio as "the square of the measure we describe," which, as Sharpe points out, would mean that it is always positive.
6. Although the Sharpe ratio is often criticized, from our research it remains the dominant risk-adjusted measure.
Stay tuned: more to follow!