Skip to content

Implications of Sharpe Ratio-II

June 27, 2009

In the previous post, “Implications of Sharpe Ratio” I redirected to a paper, a pretty recent one at that, which discussed about the apparent divorce of interests between the fund manager and a client when their intended time horizon is different.

Often in professional money management environment, there is a theory called “tournament view”. The thumb rule says, managers after a bad first half yearly performance tend to get aggressive while the managers after a topline half yearly performance tend to get mellow in risk taking. The reason explained was because they are competing for the same funds, and they have to show some comparable results when pitted against each other.

The paper doesnt this deny, but offers a more mathematically rigorous explanation for this phenomenon.

The authors hit in one of the basic points of Sharpe Ratio and its implications. It argues, that SR creates a tension between the long term goals and the short term goals. The goals can belong to either of the two- manager or the client.

Considering returns are independent,identically distributed, then if there are two cases of management where one of them intends to maximise the long term Sharpe Ratio while the other intends to maximise the short term Sharpe Ratio, say six months SR. The difference in returns visible are extremely drastic in shocking after a respectable amount of time has passed. It varies from even 35%-80% difference, depending on the strategy employed, trend following or mean reverting.

Whats striking is, the authors argue that in case a firm has lower than expected return in the first half, to maximise the short term SR, they would go aggressive in the second term and vice versa to protect their returns for those who have done well in the first half.

Interestingly, a chunk of the paper is devoted to the continous time series optimisation of Sharpe Ratio.

So, if you ask me, I think keeping a two year lock in period [which is prevalent in present day Hedge Funds] is acceptable, for a near-optimal returns.

Advertisements
No comments yet

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: