Sharpe Ratio Explained (Logic, Examples And Trading Strategies)

What is a good Sharpe ratio? Every trader is looking to find high Sharpe Ratio strategies. The Sharpe Ratio is a popular and widely used indicator for comparing the return and its risk. The name is given by its inventor, William Sharpe, who developed the ratio during the 1960s. Sharpe later won the Nobel Prize in economics in 1990 for his contributions to the financial industry. This article explains what the Sharpe Ratio is and seeks to clarify what a good Sharpe Ratio is.

The Sharpe Ratio measures the excess return compared to the risk-free rate per unit of risk. A good Sharpe Ratio is preferably above 0.75, but be careful if it’s above 1.5.

Risk is measured in terms of volatility. The ratio is used for any asset and its return, but mainly for funds that try to smooth the returns, for example, hedge funds and traders. It’s used less for traditional mutual funds.

A hedge fund’s Sharpe Ratio – the logic behind the Sharpe Ratio

Let’s first explain the simple logic behind the Sharpe Ratio. We use a practical example from one of Europe’s oldest and largest asset managers: The Swedish Brummer & Partners.

They have been 25 years in the business and manage about 10 billion USD spread among about ten different hedge funds across all asset classes. Below is their equity curve, which shows how their Multi-Strategy has performed since 2002:

The red line is the Multi-Strategy, a fund that allocates capital to about 10 different funds to diversify and smooth returns, while the grey line is the MSCI World Index.

They both have about the same return, but Multi-Strategy has smaller drawdowns. Because of this, the Sharpe Ratio is much higher: 1.11 vs. 0.39. The difference should give a pretty good idea of what the Sharpe Ratio is all about:

If your strategy is volatile, you need to be compensated in the form of higher returns. When you evaluate an investment, professional managers look at the returns and the associated risks. It doesn’t make sense to earn a little more if you face the possibility of a higher drawdown (and subsequent risk of ruin if you use leverage). All things equal, investors prefer the smoothest returns. Every hedge fund wants a high Sharpe ratio – preferably above 1.

Nevertheless, risk is very much a personal preference.

If you are young, you can take greater risk in your portfolio because you have more time until retirement, while someone closer to retirement might be more conservative to avoid a significant drop just before he or she starts withdrawing money.

The balance is difficult, and no mathematical number has ever predicted the future accurately.

Behavioral risk and the Sharpe Ratio

Some readers might ask if it matters what the Sharpe Ratio is as long as the total return is the same. That’s a good question, and you are not alone. Even Warren Buffett has repeatedly said volatility is a poor measurement of risk.

However, the math tells us that a 50% drawdown needs a 100% return to break even. Likewise, if you’re a long-term investor, a huge drawback puts a spanner in the works for your compounding.

Even worse, if you are leveraged, you might be wiped out. As Taleb says: Never cross a river that is on average four feet deep.

We know that many traders and investors make behavioral mistakes. They sell during a panic, for example. The idea is that less volatility in the returns makes investors less likely to make irrational decisions. Moreover, a higher Sharpe Ratio means you can potentially increase the leverage.

How is the Sharpe Ratio calculated?

The Sharpe Ratio’s main idea is that investors should be compensated for the additional risk they undertake above the risk-free rate.

In most cases, the risk-free rate is the 90-day Treasury Bill, which is regarded as the safest on the planet. If you own assets other than short-term Treasuries, you need to be compensated.

The formula can be broken down, in plain English, into this: The difference between the return of the portfolio and the risk-free return, divided by the standard deviation of the portfolio’s return:

(return on the investment/portfolio – the risk-free rate) / standard deviation of the investment returns

Let’s make a practical example: If your portfolio has returned 10%, the risk-free rate is 1%, and the standard deviation is 12%, the Sharpe Ratio would be 0.75 – a pretty good number over many years.

What is a good and bad Sharpe Ratio?

Money managers aim for a high Sharpe Ratio – as high as possible. The Sharpe Ratio’s main determinants are the return over the risk-free return and the smoother the returns are (small variations in the returns). If your portfolio makes 0.5% per month like clockwork, for example, the ratio is high.

We can argue the ratio should be above 1, which means the returns are greater than the risk. Excellent traders have a higher Sharpe Ratio, but many traders “blow-up” after a while (see more about Nassim Taleb below). We believe a Sharpe Ratio above 0.75 is good if obtained over many years.

In practice, very few funds manage a ratio above 1, like Brummer & Partner in the example above. A Sharpe Ratio above 1.5 is extraordinary.

Opposite, a Sharpe Ratio below 0.5 could be improved. If the Sharpe Ratio is negative, the return is worse than the risk-free rate, and you would be better off in Treasuries.

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