Sharpe ratio

A risk adjusted measure of performance, introduced by William Sharpe and now the default figure quoted alongside a track record. The numerator is the return in excess of a risk free rate over the period. The denominator is the standard deviation of that excess return, measured over the same period. A higher figure means more return was obtained per unit of variability, and a figure computed on monthly data is conventionally annualised by multiplying by the square root of the number of periods in a year.

Three choices decide the answer before any performance does: the length of the sample, the proxy used for the risk free rate, and the frequency the returns are measured at. The annualisation step also assumes returns are independent from one period to the next, which is exactly the assumption a trending or a mean reverting series breaks. Two ratios quoted for the same strategy are therefore only comparable once all three choices are stated, and they frequently are not.

The standing criticism is about the denominator. Standard deviation treats an unusually good period as risk in the same way it treats an unusually bad one, so a strategy that produces small steady gains and rare large losses scores well right up until the loss arrives. This is the reason the Sortino ratio, which uses only downside deviation, exists, and the reason a drawdown figure is usually read beside a Sharpe ratio rather than in place of it. How much comparability the measure really delivers across different kinds of strategy is genuinely disputed.