Sharpe Ratio

Basics

• Measures excess return vs. risk taken
• Created by William Sharpe in a paper The Sharpe Ratio
• Common measure of a funds quality
• Calculated by (Funds Return - Risk Free Return) / Standard Deviation of returns
• The more risks you take the greater your returns should be
• Higher values are considered better

Problems with Sharpe Ratio

• Uses standard deviation of returns or volatility to mean risk
• Volatility doesn't handle Event Risk where event has yet to occur
• Selling put options can give you good returns, from the premium, with low vol. This is risky and the vol measure doesn't show it
• A fund can take risks that don't show up in volatility
• Can hide the true risk of an investment strategy
• Sharpe Ratios can appear higher then they should be if there is hidden event risk since it won't be included in the divisor of volatility