Stephen Cooper

Hedge Fund Sharpe Ratio

The Sharpe Ration used by Hedge Funds.

Although to “Hedge” a bet is to protect against loss by betting a counterbalancing amount against the original bet, “Hedge in the financial world is a transaction that reduces risk. Yet, Hedge Funds suffered severely during the late seventies as the risk could not be identified exhaustively by the fund managers, investors, broker-dealers and all others directly or indirectly involved in the deals.

Besides, most macro Hedge Funds took positions mainly in the mature markets, some even in the emerging markets. Quite a number of large macro funds did both, spreading their holdings across equities, bonds and currencies, taking both short and long positions. In addition, they held commodities and other liquid assets like real estates. But the majority of the macros held a more limited range of assets, allocating a fraction of their portfolios to emerging markets where risk of the concentrated stakes were very high.

Hence, measurement of return per unit of risk became necessary. Here the Sharpe Ratio proved effective. When interpreting the value of an investments Sharpe ratio, it is of primary importance to evaluate the formula behind the number. However, it would be prudent to take a closer look at the basic analytics behind the Sharpe ratio and only then consider the effect each component may have on the calculation. Although the Sharpe ratio is generally presented in a simplified form as a single value, grasping the unsolved construction may provide further comprehension. In short, the equation that may guide us in this particular field runs like this...

Average monthly Return(x)

Monthly Sharpe Ratio(x) = _______________________

Monthly standard deviation(x)

The numerator is the difference between an investor’s average monthly performance and the rate of return (ROI) of a designated risk-less alternative. Here, it is significant to note the placement of these components in the equation. When all other factors are constant, an increase in the excess returns of an investment will result in a greater Sharpe ratio. The opposite is true for the denominator which is a monthly standard deviation, a measurement of the investment’s volatility.