Sharpe ratio
What is Sharpe ratio?
The Sharpe ratio measures average return above a risk-free reference per unit of total return volatility.
Palance should use a documented, horizon-consistent risk-free series and calculate excess returns at the same frequency as portfolio returns. The display needs period, annualization, gross or net basis, and observation count. Comparisons across illiquid and liquid assets require caution because stale marks suppress measured volatility.
Negative excess return makes rankings particularly unstable and should not be simplified into a universal quality label.
Rolling displays should use enough data to avoid unstable rankings and show the numerator and denominator beside the ratio. When the risk-free rate changes materially, apparent improvement or deterioration should not be attributed wholly to the portfolio manager.
Formula
Sharpe ratio equals portfolio return minus risk-free return divided by portfolio volatility, with numerator and denominator expressed on compatible horizons. It can be calculated from periodic excess returns and annualized. Arithmetic and geometric conventions differ, especially over long horizons. The exact method and risk-free proxy must be disclosed.
Interpretation
A higher ratio indicates more historical excess return for measured variability, not automatically a better or suitable investment. The ratio does not reveal return magnitude, drawdown, liquidity, leverage, skew, or tail risk. Negative ratios are difficult to rank because adding risk can make a negative value appear closer to zero.
Example
A portfolio returning 9% with a 3% risk-free rate and 12% volatility has a simplified Sharpe ratio of 0.5. This annual subtraction illustrates the concept, but a rigorous calculation should use aligned periodic excess returns. Fees, tax, currency, and observation window can materially change the investor-relevant result.
Comparability
Compare portfolios over the same period, currency, frequency, annualization, and risk-free series. Smoothed private marks and illiquid pricing can understate volatility and inflate ratios. Leverage can leave Sharpe broadly similar under ideal assumptions while increasing drawdown, funding, and solvency risk. Capacity and transaction costs can reduce live performance.
Limitations
The measure assumes volatility is an adequate risk summary and can be unstable in small samples or changing regimes. Option-selling strategies may show high ratios before rare losses. Pair Sharpe with drawdown, Sortino ratio, tail risk, exposure, liquidity, and qualitative diligence. It is an evaluation tool, not a forecast or guarantee.
Sources and further reading
- Portfolio Performance Evaluation, CFA Institute
- Understanding Investment Performance, FINRA