Sharpe ratio, key hedge fund risk gauge is 'flawed'
By Nassim Taleb (Reuters, 23 July 2006)
The Sharpe ratio is a measure of risk-adjusted return. It is the difference
between returns and a risk-free interest rate - often the yield on US
Treasury bills - divided by the volatility or range of possible returns.
It has been used in recent years to persuade investors such as pension funds
that it is less risky to invest in hedge funds than equities.
The Sharpe ratio, a key measure of performance used by hedge funds to
sell themselves, is flawed and tells investors nothing about the risks they
are taking, Nassim Nicholas Taleb, a hedge fund investor and a professor in
the sciences of uncertainty at the University of Massachusetts.
“It’s used for marketing. It looks sophisticated, but the volatility part
is not a good measure of risk,”. “The Sharpe ratio is like a horoscope ... A
startlingly high number of people rely on this bogus theory ... It’s a big
scam by finance professors ...” said Taleb in an interview earlier this
week.
At the root of the problem is the assumption that economics and finance are
solid sciences, which allows the use of statistical tools such as the law of
averages and the normal distribution to model returns.
Being normally distributed means that most outcomes will fall within a
narrow range either side of the mean.
But the idea can only be applied to things like weight or height, where an
extreme reading will not distort the mean if the sample of people is large
and representative.
It cannot be applied to exceptional extreme events in finance such as large
losses or gains that will continue to dominate the picture no matter how
large the sample gets.
“If the exception doesn’t matter in the long-run, then the law of averages
applies ... If the exception continues to dominate the sample even if the
sample becomes very large, you can’t use the normal distribution,” Taleb
said.
“It can’t be applied to socio-economic variables ... An example is stock
market returns ... In the last 50 years, 10 days represented more than half
of stock market returns.”
Hedge fund returns are another example. US-based Long Term Capital
Management (LTCM) collapsed in 1998 in the wake of the emerging market
crisis as liquidity dried up because of large trading losses using a model
based on the law of averages.
“LTCM had lots of small up months and a few large down months,” Taleb said.
“This is not detected by the Sharpe ratio as it assumes a symmetry in the
distribution of returns.”
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