A Critique of the Sharpe Ratio

Author: David Harding, Winton Capital Management

The Sharpe ratio is a statistic which aims to sum up the desirability of a risky investment strategy or instrument by dividing the average period return in excess of the risk-free rate by the standard deviation of the return generating process. Devised in 1966 as a measure of performance for mutual funds, it undoubtedly has some value as a measure of strategy "quality" but it also has several crucial limitations. Furthermore, its widespread and often indiscriminate adoption as a quality measure is leading to distortion of proper investment priorities, as investment firms manipulate strategies and data to maximise it.