The Sharpe ratio is an important metric for evaluating performance in finance world. However, calculations of this ratio in backtesting and portfolio tracking software are usually not accurate. In this article, we present the main reason for the discrepancies and provide a formula for improved Sharpe ratio calculation. Access to article requires Premium Insights subscription.
The Sharpe ratio measures risk-adjusted performance. A higher Sharpe ratio is always desirable ceteris paribus. For example, a trading strategy with Sharpe ratio of 1.2 is better than one with Sharpe 0.8, provided return objectives and maximum drawdown constraints are satisfied, among other requirements.
For example, Sharpe for an equity market trend-following strategy with 10% annualized return and 10% annualized standard deviation is 1.00 (assuming zero risk-free rate). At the same time, Sharpe of a volatility trading strategy with 60% annualized return and 50% annualized standard deviation is 1.2. The higher Sharpe of the volatility strategy does not mean it is a “better” one. Another criterion for selection could be MAR. In this example, MAR for the trend-following strategy could be 0.4 but for the volatility strategy could be 0.17. Therefore, Sharpe may not be the only criterion traders and investment managers use to evaluate performance. In the example, if higher MAR is desired, then the trend-following strategy is a “better” choice.
Furthermore, Sharpe ratios reported by backtesting and portfolio management software may not be calculated correctly when returns are not i.i.d. (independent and identically distributed.) Below we provide a formula for the calculation of the Sharpe ratio to account for deviations from i.i.d. requirement.
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