Measuring returns relative to the risk taken may be inadequate and often misused in evaluating investments, asset classes, and managers, according to Aon Hewitt.
Risk-adjusted return metrics, including Sharpe ratios, “can only do so much and should be used along with other tools,” argued consultant Bob Penter.
While many risk-adjusted return measures aim to equate units of return to units of risk, this definition often goes against investment objectives of real return achieved by the investor, he continued.
“A high Sharpe ratio is inadequate if the returns are too low,” Penter wrote in a blog post. “Stated differently, you can’t ‘eat’ a Sharpe ratio.”
Risk-adjusted returns also focus on annual or annualized returns, contrary to institutional investors’ long-term time horizons.
In addition, Penter wrote Sharpe ratios could lead to distorted comparisons of equities or hedge fund managers because they give credit to managers that reduce the portfolio’s market risk.
“An investor searching for a large cap US equity manager, for example, already has made an explicit choice to take on the risk associated with that asset class,” he said. “The investor has already allocated its risk budget to account for the market risk.”
The consultant also argued that while risk-adjusted returns for an asset or manager may look good on a standalone basis, the result is like to change in the context of a broader portfolio.
For example, a risk-oriented manager who has a Sharpe ratio of 0.32 may appear superior to the return-oriented manager with a Sharpe Ratio of 0.26. However, in a balanced portfolio with public equities and bonds, the return-oriented manager delivered a 0.4 Sharpe ratio, compared to the risk-oriented manager’s 0.37.
“The impact of two investments on the portfolio risk may be very different,” the consultant concluded, “depending on the other assets in the portfolio and the correlations of returns.”