The Holy Grail of investing is to find assets that are low in risk, and high in return.

Unfortunately, the two are anticorrelated: putting money in your mattress isn’t very risky, but unlikely to make you rich. Whereas investing in some dropout’s startup is extremely risky, but could make you a billionaire.

One way that institutional investors, like top hedge funds, global family offices, and the best investment clubs, quantify that tradeoff is with a quantity called the Sharpe Ratio. In this article, we’ll define what the Sharpe Ratio is, and explain how hedge fund managers use it in investing.

Sharpe Ratio

The Sharpe Ratio quantifies the tradeoff between risk and return. For example, a Sharpe Ratio of 2 means investors can reasonably expect 2 units of return for every 1 unit of volatility. The Sharpe Ratio is used to analyze individual investments and compare investments to each other. In this note, we’ll explain the Sharpe Ratio and discuss how professional investors use it.

Sharpe Ratio Measures Consistency of Returns (i.e., returns per unit of volatility)

Investments with consistent returns will have a higher Sharpe Ratio than investments with volatile returns. For example, investments that average 5% annually with low volatility will have a bigger Sharpe Ratio than investments averaging 30% per year with volatile returns (i.e., the investment is up 20% one month and down 15% the next month, etc.).

Interestingly, the Sharpe Ratio for investments with no drawdowns but volatile upside returns will be smaller than investments with drawdowns if returns have low volatility. In other words, the Sharpe Ratio measures returns per unit of volatility. Volatility is associated with “risk” because the wider the range of historical returns, the more uncertain the outcome going forward (i.e., more “risk”). That is why the Sharpe Ratio is also defined as a measurement of “risk-adjusted return”.

The Sharpe Ratio calculation divides the average “excess return” (returns in excess of a “risk-free” rate) to the standard deviation. In other words, the Sharpe Ratio calculation is complex. However, most people only need basic understanding to make the Sharpe Ratio useful.

Using the Sharpe Ratio

In practice, the Sharpe Ratio has two uses. First, investors gauge how consistent an investment’s returns are expected to be going forward. Second, investors can compare investments with different returns and risk profiles to each other (i.e., compare “apples to apples” so-to-speak). For example, consider the list of potential investments below.

Which is the best opportunity?

Investment #3 has 3x the average return compared to Investment #1, but also 15x the volatility. A Sharpe Ratio of 0.2 means volatility of the returns is 5x the average return. Some investors may not want investments that are up 10% one month and down 15% the next month, etc., even if the investment offers a higher overall average return.

Sharpe Ratio General Ranking:

< 1 Inadequate risk/return profile

1 – 2 Strong risk/reward skew

2 – 3 Very strong risk/reward skew

> 3 Excellent risk/reward skew

Sharpe Ratio – Drawbacks

Statistical analysis is never perfect and investors should be cautious when using the Sharpe Ratio to make investment decisions.

First, although the Sharpe Ratio is often defined as measuring “risk-adjusted returns”, the Sharpe Ratio actually measures volatility of returns, not necessarily “risk”. For example, an investment with no drawdowns might have a lower Sharpe Ratio than another investment that has had several losing months. The reason is that the Sharpe Ratio calculation penalizes volatility; if the first investment has never had loss but returns are volatile, the Sharpe Ratio will be lower than an investment with more consistent returns.

Second, past performance does not guarantee future results. Even though an investment may have a high Sharpe Ratio, that does not guarantee consistent returns (low volatility) going forward. The Sharpe Ratio analyzes past performance and historical volatility. The Sharpe Ratio provides a reasonable expectation of what to expect going forward, but the future will always be uncertain and future performance can be (and often is) different than past performance.

For more information, contact Ariel Shlien at Surefire Capital: ariel@surefirecapital.com