Risk Gets Riskier
Institutional Investor (10/02) Vol. 36, No. 10 p.28; Lux, Hal

For nearly 40 years, investors have relied on the Sharpe ratio to give them an indication of how much of their investment they can expect back for every unit of risk they invest; however critics of the concept--including founder William Sharpe--have begun to question the reliability of the ratio. Leading analysts and academics agree that the Sharpe ratio often leads to overstated figures. According to them, it is simply too easy to manipulate the Sharpe ratio by modern trading strategies. One major flaw with the concept is its ability to conceal inherent uncertainty in predictions of future returns. For example, mutual funds that appeared healthy prior to the market slump showed solid Sharpe ratios. "I take the point that Sharpe ratios can give a false sense of precision and lead people to make predictions unwisely," Sharpe says. Critics also complain that Sharpe ratios discount certain risks such as small-capitalization stocks, and that investors depend on the ratio too much in troubled markets. Increasingly, the segment of investors who run into the most trouble in this department are hedge fund investors.

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