The metric's creator says using it to select individual funds isn't enough for a strong portfolio
It would be so much easier for advisors if they could just select each fund in their clients’ portfolios based on its Sharpe ratio. But unfortunately, selecting funds is not quite that simple — and you can take it from Dr. Sharpe himself.
Seasoned advisors know that the Sharpe ratio represents the amount of excess return that investors can expect from a fund for the degree of risk they take; the higher the ratio, the better the risk-adjusted performance. Therefore, one might assume that the ideal portfolio will result from selecting investments with the highest Sharpe ratios.
But according to the ratio’s creator Dr. William Sharpe, who is also a Nobel laureate and Stanford University finance professor emeritus, a portfolio is more than the sum of its parts. “The Sharpe ratio, in its traditional form, ought to be used primarily for one’s whole portfolio,” he recently told the Wall Street Journal.
He pointed out that a fund’s risk is derived from the volatility in its own returns. But in a portfolio of funds, risk is affected by other variables such as asset correlation and longevity, a subject that Sharpe has discussed extensively in an online resource of retirement income scenario matrices.
He also noted the importance of cost. Funds with high Sharpe ratios could still end up as net underperformers if they have high fees attached. When asked about hedge funds that charge “2 and 20” fees — basically charging a 2% management fee on assets plus 20% of any profit they make — he had this to say:
“It’s easy to go long this and short that and charge 2 and 20. But to make your clients better off, it’s a pretty hard argument to make.”
Weighing in on the active vs. passive debate in investments, he noted that high fees represent barriers to outperformance. In other words, active managers that want to compete against low-cost ETFs, but charge high fees, are getting in their own way.
“The average active manager, net of costs, will underperform the passive manager by the difference [of their expenses],” he said.
Related stories:
Is the industry relying too much on Morningstar ratings?
Mutual fund costs dropping in Canada
Seasoned advisors know that the Sharpe ratio represents the amount of excess return that investors can expect from a fund for the degree of risk they take; the higher the ratio, the better the risk-adjusted performance. Therefore, one might assume that the ideal portfolio will result from selecting investments with the highest Sharpe ratios.
But according to the ratio’s creator Dr. William Sharpe, who is also a Nobel laureate and Stanford University finance professor emeritus, a portfolio is more than the sum of its parts. “The Sharpe ratio, in its traditional form, ought to be used primarily for one’s whole portfolio,” he recently told the Wall Street Journal.
He pointed out that a fund’s risk is derived from the volatility in its own returns. But in a portfolio of funds, risk is affected by other variables such as asset correlation and longevity, a subject that Sharpe has discussed extensively in an online resource of retirement income scenario matrices.
He also noted the importance of cost. Funds with high Sharpe ratios could still end up as net underperformers if they have high fees attached. When asked about hedge funds that charge “2 and 20” fees — basically charging a 2% management fee on assets plus 20% of any profit they make — he had this to say:
“It’s easy to go long this and short that and charge 2 and 20. But to make your clients better off, it’s a pretty hard argument to make.”
Weighing in on the active vs. passive debate in investments, he noted that high fees represent barriers to outperformance. In other words, active managers that want to compete against low-cost ETFs, but charge high fees, are getting in their own way.
“The average active manager, net of costs, will underperform the passive manager by the difference [of their expenses],” he said.
Related stories:
Is the industry relying too much on Morningstar ratings?
Mutual fund costs dropping in Canada
