Alternative to the Sharpe Ratio https://blog.sutherlandresearch.com/index.php/2017/05/27/alternative-t...

PJ Sutherland

A well-known and often quoted measure of risk is the Sharpe ratio. Developed in
1966 by Stanford Finance Professor William F. Sharpe, it measures the
desirability of an investment by dividing the average period return in excess of the
risk-free rate by the standard deviation of the return generating process. In
simple terms, it provides us with the number of additional units of return above
the risk-free rate achieved for each additional unit of risk (as measured by
volatility). This characteristic makes the Sharpe ratio an easy and commonly used
statistic to measure the skill of a manager and can be interpreted as follows: SR
>1 = lots of skill, SR 0.5-1= skilled, SR 0-0.5 = low skilled, SR = 0 = no skill and
conversely for negative numbers. Although the Sharpe ratio can be an effective
means of analysing investment performance, it has several shortcomings that one
needs to be aware of and which I’ll discuss below. But before I do, here is the
formula for calculating the Sharpe ratio:

(Mean Portfolio Return – Risk-Free Rate) / Standard Deviation of

Portfolio Return

The most obvious and glaring flaw is the fact that the Sharpe ratio does not
differentiate between upside (good) and downside (bad) volatility. Thus, a
performance stream that experiences more positive outliers (a good thing for
investors) will simultaneously experience elevated levels of volatility which will
decrease the Sharpe ratio. This means that one can improve the Sharpe ratio for
strategies that exhibit a positive skew in their return distribution (many small
losses with large infrequent gains), for instance trend following strategies, by
simply removing some of the positive returns, which is nonsensical because
investors generally welcome large positive returns.

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Alternative to the Sharpe Ratio https://blog.sutherlandresearch.com/index.php/2017/05/27/alternative-t...

On the flipside, strategies with a negative skew in their return distribution (many
small gains with large infrequent losses), for instance option selling strategies, are
much riskier than the Sharpe ratio would have us believe. They often exhibit very
high Sharpe ratios while they are “working” because they tend to produce
consistent small returns that are punctuated by rare but painful negative returns.

The reason for the shortcomings discussed above can be attributed to the fact that
the Sharpe ratio assumes a normal distribution in returns. Although strategy and
market returns can resemble that of a normal distribution, they generally are not;
if they were then we would expect some of the market moves we’ve experienced
within the last decade to occur once in a blue moon, but they evidently do not.
This is the result of the phenomena referred to as “fat tails”, or the market’s
higher probability of realising more extreme returns than one would expect from
a normal distribution. This, in and of itself, is reason enough to be dubious of
blindly evaluating a manager or strategy’s performance based on a Sharpe ratio
without an understanding of exactly how the returns are made.

One also needs to place the reason for the Sharpe ratio’s initial development into
perspective. It was conceived as a measure for comparing mutual funds, not as a
comprehensive risk/reward measure. Mutual funds are a very specific type of
investment vehicle that represent an unleveraged investment in a portfolio of
stocks. Thus, a comparison of mutual funds in the 60’s, when the Sharpe ratio
was developed, was one between investments in the same markets and with the
same basic investment style. Moreover, mutual funds at the time held long-term
positions in a portfolio of stocks. They did not have a significant timing or trading
component and differed from each other only in their portfolio selection and
diversification strategies. The Sharpe ratio therefore was an effective measure to
compare mutual funds when it was first developed. It is however not a sufficient
measure for comparing alternative investments such as many hedge funds
because they differ from unleveraged portfolios in material ways. For one thing,
many hedge funds employ short-term trading strategies and leverage to enhance
returns, which means when things go wrong money can be lost at a far greater
rate. Moreover, they often do not provide the same level of internal diversification
nor have lengthy track records.

Investors that do not understand the difference between long-term buy-and-hold

investing and trading, often incorrectly measure risk as smoothness in returns
with the Sharpe ratio. Smoothness does not equal risk. In fact, there is often an
inverse relationship between smoothness and risk – very risky investments can
offer smooth returns for a limited period. One need only consider the implosion
of Long-Term Capital Management which provided very smooth and consistent
returns (excellent Sharpe ratio) before being caught in the Russian default on
bonds which created a financial crisis.

The strategies that we employ in QuantLab would be categorised as alternative in

nature and do not mimic typical mutual funds. Therefore, the Sharpe ratio is not
the most suitable measure to assess our performance. So, let’s examine a couple
of alternatives to the Sharpe ratio.

The Sortino ratio is like the Sharpe ratio but differs in that it takes account of the
downside deviation of the investment as opposed to the standard deviation – i.e.,
only those returns falling below a specific target, for instance a benchmark.
Formula:

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Alternative to the Sharpe Ratio https://blog.sutherlandresearch.com/index.php/2017/05/27/alternative-t...

(Mean Portfolio Return – Risk-Free Rate) / Standard Deviation of

Negative Portfolio Returns

The Sortino ratio in effect removes the Sharpe ratio’s penalty on positive returns
and focuses instead on the risk that concerns investors the most, which is
volatility associated with negative returns. It is interesting to note that even Nobel
laureate Harry Markowitz, when he developed Modern Portfolio Theory (MPT) in
1959, recognized that because only downside deviation is relevant to investors,
using it to measure risk would be more appropriate than using standard
deviation.

We can see the effects of removing the penalty on positive outliers with the
Sortino ratio by examining our live performance in QuantLab, which to date
exhibits a strong positive skew – we’ve enjoyed several large positive outliers – so
the Sharpe ratio unfairly penalises our performance. In fact, if we remove the
effect of positive volatility (good for investors), QuantLab’s risk-adjusted
performance improves from 1.11 (Sharpe) to 1.85 (Sortino). However, since the
return stream of QuantLab is asymmetric, that is it displays skew and is not
symmetric around the mean, the standard deviation is not an adequate risk
measure (as discussed above). Although the Sortino ratio improves on the Sharpe
ratio for performance profiles that exhibit positive skew, it still suffers from the
flawed assumption that returns are normally distributed, which is required when
using the standard deviation to measure risk.

There is however an alternative risk/reward measure free of the shortcomings

discussed above which I personally prefer to use when evaluating performance.
I’ll explore this measure next.

In an absolute sense, the most critical risk measure from an investors perspective
is maximum drawdown because it measures the worst losing run during a
strategy’s performance. A pragmatic approach then to measuring risk/reward is
to determine how well we’re compensated for assuming the risk associated with
drawdown. This is precisely what the MAR ratio achieves. It was developed by
Managed Accounts Reports (LLC), which aptly reports on the performance of
hedge funds. The ratio is simply the compounded return divided by the maximum
drawdown. Provided we have a large enough sample, the MAR ratio is a quick and
easy to use direct measure of risk/reward; It tells you how well you’re being

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Alternative to the Sharpe Ratio https://blog.sutherlandresearch.com/index.php/2017/05/27/alternative-t...

compensated for having to risk your capital though the worst losses. The formula
follows:

CAGR / Max DD

l find this ratio immensely useful. It’s simple, does not rely on flawed assumptions
about market return distributions such as standard deviation, which is used in
both the Sharpe and Sortino ratios, and it measures what’s important to
investors: the number of units of return delivered for every unit of direct risk
(maximum drawdown) assumed. When we use this metric to measure our live
performance to date we find that QuantLab has delievered three units of return
for every unit of risk, that is, our live MAR ratio is currently 3.

The MAR ratio is a transparent and direct measure of risk and reward that is
impossible to manipulate (the Sharpe and Sortino ratios can be manipulated
higher in several devious ways) and is thus my preferred measure of risk-adjusted
performance when evaluating strategies.

We all have unique return expectations and tolerance for pain. For this reason,
there is no single measure that appeals universally to everyone. In my personal
trading, I analyse the MAR ratio, maximum drawdown, overall return and like to
keep an eye on the smoothness in which returns are generated by examining the
Coefficient of Variation, Sharpe and Sortino ratios. Keep in mind that regardless
of the statistic you use, they are good estimates at best. Therefore, one can never
be too conservative when analysing past performance. Given a long enough
timeline, every strategy will exceed its maximum drawdown. This is a harsh
reality that we as traders need to accept and prepare for, so it’s a good idea to be
suspicious of any statistic and ensure we have buffers built into our expectations
to handle new extremes that will likely be posted in the future.

As always, I welcome your thoughts and suggestions.

Happy Trading,
PJ

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