David Harding Offers Sharpe Ratio Criticism

David Harding of trend follower Winton Capital argues for more than simple acceptance of the Sharpe ratio as the measure for assessing “risky investments”:

“The Sharpe ratio appears at first blush to reward returns (good) and penalise risks (bad). Upon closer inspection, things are not so simple. The standard deviation takes into account the distance of each return from the mean, positive or negative. By this token, large positive returns increase the perception of risk as though they could as easily be negative, which for a dynamic investment strategy may not be the case. Large positive returns are penalised, and thus the removal of the highest returns from the distribution can increase the Sharpe ratio: a case of reductio ad absurdum for Sharpe ratio as a universal measure of quality! We might suggest an improvement by considering only the negative semi-standard deviation for the denominator, a measure known as the Sortino ratio. However it still remains vital that the semi-standard deviation used is meaningful, in the sense that it is calculated from a sufficiently well-understood return distribution, where the assumptions of stationarity and parametricity can be made.”