The Universal Nature of The Sharpe Ratio

Apr 29, 2010 in Volatility

Lets look at 3 common methods different investors use to reach their goals:

Investment Advisors:  a typical advisor buys a combination of stocks and bonds to dilute/diversify the risk of owning stocks alone.   They participate in bull markets but give up pure equity returns in pursuit of stability.  The bond component to portfolios is generally uncorrelated to equities in down equity markets.  The stock portion of a portfolio is compared to a stock index and the total portfolio is compared to a blended stock-bond index.

Options Players Selling Covered Calls:  This group buys the underlying stocks/ETFs and sells calls to earn extra income.  If the securities go up, their securities make money.  The also earn the premium and the stocks are called away.  Like the advisor, they give up some upside in order to outperform in down markets (the calls they sell expire worthless to the purchaser and the income they make results in outperformance vs an index return).  

Hedge Fund Long-Short Portfolio:  This group holds longs and shorts.   They generally have a long bias to catch upward nature of equities – but once again, their short positions protect them in down markets and dilute overall volatility.  This strategy tends to avoid drawdowns well but generally does not perform as well as the first two strategies in bull markets.   Essentially, the long-short portfolio is not unlike holding a mostly bond portfolio -- with a small long equity component.   Think something like: 90% bonds with 10% midcap US stocks.  Or 90% bonds with 10% emerging markets exposure.   These kinds of portfolios are very tame -- don't drawdown much and can participate in part when equities do well.  The hedge fund will not have interest rate risk so it won't act like the bond portfolios in reality -- but it is a fair comparison from a volatility perspective. 

The Sharpe Ratio does a good job of enabling a comparison of these different methods.  

The actual calculation of the Sharpe Ratio seems simple enough – though perhaps it is not as straightforward as you may at first think.  ETFreplay.com calculates the Sharpe Ratio as the AVERAGE daily excess total return divided by the daily standard deviation.  Note that the denominator is the same way an options market maker calculates realized volatility.  The mean return and the standard deviation of return is the standard way you describe any 'distribution' of returns.  We are unique though in that we calculate TOTAL return.  We do this because ETF's represent underlying indexes --- and an index return is ALWAYS stated as total return.   We are shocked at how poorly this concept is understood by professional websites, bloggers and aggregation sites like Seeking Alpha.  The difference is at times significant.   

In each of the mentioned strategies above, the standard deviation is being diluted with some kind of paired combination of either bonds, call selling or short selling.    These are all good ideas because when you reduce volatitlity, you increase your chances of improving your Sharpe Ratio.   If there is one statistic every investor should learn -- it is the Sharpe Ratio.   ETFreplay.com makes it easy to understand because our charts de-compose the numerator and the denominator into visual bar charts.

If you focus only on the return of a benchmark and not Sharpe – you will get caught in the same problem the mutual fund industry has – chasing an index around in fear of losing to it in the short-run.  You end up as a closet index, your performance looks great in a bull market --- but you invariably end up with low long-term returns due to the occasional large drawdown.   

We like the combination of finding good relative strength investment opportunities -- and combining that with keeping an eye on your overall portfolio volatility.  By relative strength, we don’t just mean limiting yourself to any one thing – such as U.S. equities.   We mean looking globally and across asset-classes.  The ETF market allows so many more interesting things on a global scale --- find global, cross asset-class relative strength and overweight these segments.

In the above 3 strategies, all of them essentially have portfolios with standard deviations set intentionally BELOW the S&P 500.   How far below is up to each investors ability and willingness to take risk.  But in the long-run, it is not hard to beat the S&P 500's sharpe ratio -- as the reward-risk relationship of the S&P 500 is quite poor -- you get a lot of volatility without a lot of return over the long-run.

We hope that our charts, our screener, our backtesting applications and all of the other pages we have created do a good job of taking portfolio concepts and making them visual and easy.  This is what 'data visualization' is all about.  We very deliberately designed the entire website with the Sharpe Ratio in mind.

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Comments (7) -

Apr 29, 2010 10:26 #

That is why in your ETF screener it would be great if we could see the Sharpe ratio for each ETF over the last 1,3 or 6 months, and sort based on this rather than just seeing the ranking.

Kevin_in_GA United States

Apr 29, 2010 11:12 #


Thanks and we appreciate your suggestion and will get to a page that shows this.

By doing it as a ranking -- you can rank the securities more cleanly when trailing returns are negative.  A really high sharpe ---  or a really low (that is, a negative sharpe ratio) are both ultimately meaningless.  The real issue is the long-term return and the intermediate drawdowns.  The volatility number by itself serves as the drawdown warning -- and the returns show strength or weakness vs other ETFs.

ETFreplay United States

Apr 30, 2010 08:03 #

Agree on all points.   looking at relative strength (essentially highest alpha-generating ETF for a given time period), it seems to be the overall driver for ETF selection, with the drawdown as a moderating influence.  In your RS backtest, during major market corrections, it is often the excess return that pushes SHY up to the top of the list, as much as low drawdown.

Kevin_in_GA United States

Apr 30, 2010 14:45 #


I assume you mean that SHY will have more return than others in the group.   SHY will never have much 'excess return' --- because 'excess return' technically means the return over the cash return -- and we are using SHY as a proxy for the cash return.  

It should be pointed out that during a bear market, you should be able to rotate into some that pays a better yield than cash and so this understates the true strategy return.   Indeed, in this last bear market, treasury bonds went straight UP on the flight to safety.   But then there is also any transaction fees -- which we did not build into the application.   Of course, firms like Schwab and Fidelity are now offering zero transaction fees on an expanding list of ETFs -- so this might not be much of a factor in the future.

ETFreplay United States

May 01, 2010 06:25 #

Excess return relative to SPY - of course SHY delivers that in downturns (the -0.15% return as seen during Feb 2009 for SPY certainly beat the -10.74% loss taken by SPY).  Even though the Sharpe ratio was negative, the choice was clear based on relative strength (alpha) as well as low volatility.

That being said, I think we are in agreement.  I have also looked at bond funds like AGG and BND, but in the end think that SHY outperforms them when you need it most (with low volatility as a criterion for my peace of mind!)

Kevin_in_GA United States

May 01, 2010 06:56 #


Yes we agree.    AGG and BND are not treasury bond funds.  Note that we list them within the corporate/credit bond grouping as they are less than 40% U.S. treasuries/agencies.

The 3-10 year duration treasury ETFs (IEI, IEF, TLH) offer a middle ground --- they appreciate on the 'flight to safety trade' -- but also aren't very volatile so when things get really violent --  you can know that your portfolio won't gyrate all that much --- just fractionally versus the market on those violent short squeezes that accompany market downturns.

Over long-run, corporate bond funds are very nice Sharpe Ratio securities.   They can drop when credit risk rises -- but the payments are fixed and the common stock needs to go to zero before that --  and then there is still going to be a recovery rate as defaulted corporate bonds do not pay off at zero.  





ETFreplay United States

Jun 08, 2012 12:50 #

Hi

If an ETF had a negative return during a year, his Sharpe Ratio will then be negative as well, correct? how to interpret it?

Thank you in advance

Guillaume

guillaume France

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