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Friday, August 12, 2022

How Sharp Is the Sharpe Ratio? An Analysis of Global Stock Indices

Investors across the globe use the Sharpe Ratio, among other risk-adjusted metrics, to compare the performance of mutual fund and hedge fund managers as well as asset classes and individual securities. The Sharpe Ratio attempts to describe the excess return relative to the risk of the strategy or investment — that is, return minus risk-free rate divided by volatility — and is among the primary gauges of fund manager performance.

But hidden within the Sharpe Ratio is the assumption that volatility — the denominator of the equation — captures “risk” in its entirety. Of course, if volatility fails to entirely reflect the investment’s risk profile, then the Sharpe Ratio and similar risk-adjusted measures may be flawed and unreliable. 

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What are the implications of such a conclusion? A common one is that the distribution of returns must be normal, or Gaussian. If there is significant skewness in the returns of the security, strategy, or asset class, then the Sharpe Ratio may not accurately describe “risk-adjusted returns.”

To test the metric’s effectiveness, we constructed monthly return distributions for 15 global stock market indices to determine if any had such exacerbated skewness as to call into question the measure’s applicability. The distribution of returns went as far back as 1970 and were calculated on both a monthly and annual basis. The monthly return distributions are presented blow. Annual return results were qualitatively similar across the various indices studied.

We ranked all 15 indices by their skewness. The S&P 500 came in close to the middle of the pack on this measure, with an average return of 0.72% and a median return of 1% per month. So, the S&P distribution skews just a bit to the left.


S&P 500 Monthly Return Distributions, Since 1970

Bar chart showing S&P 500 Monthly Return Distributions, Since 1970

The complete list of indices ranked by their skewness is presented in the chart below. Ten of the 15 indices exhibit left skewness, or crash risk: They are more prone to pronounced nose-dives than they are to steep upward climbs. The least skewed distributions were those of France’s CAC 40 and the Heng Seng, in Hong Kong, SAR.


Monthly Returns by Global Index

Index Mean Median Min. Max. STD Skewness
ASX 200 0.58% 1.01% -42.3% 22.4% 0.048 -1.3
TSX 0.60% 0.88% -22.6% 16% 0.044 -0.77
FTSE 0.53% 0.91% -27.6% 13.7% 0.045 -0.73
Russell 2000 0.84% 1.60% -21.9% 18.3% 0.055 -0.55
S&P 500 0.72% 1.00% -21.8% 16.3% 0.044 -0.45
DAX 0.67% 0.74% -25.4% 21.4% 0.056 -0.39
Nikkei 0.54% 0.91% -23.8% 20.1% 0.055 -0.37
MXX 1.23% 1.16% -29.5% 20.4% 0.066 -0.34
MOEX 1.29% 1.63% -30% 33% 0.079 -0.29
CAC 40 0.64% 0.98% -22.3% 24.5% 0.056 -0.11
Hang Seng 1.17% 1.23% -44.1% 67.3% 0.090 0.33
NSE 1.50% 1.05% -24% 42% 0.076 0.53
KRX 0.90% 0.49% -27.3% 50.7% 0.074 0.80
BVSP 5.63% 1.94% -58.8% 128.6% 0.184 2.51
SSE 1.65% 0.63% -31.2% 177.2% 0.151 6.26

The Shanghai Composite has exhibited the greatest degree of right skewness over time, tending to crash up more than down, and otherwise generating average returns of 1.65% per month and median returns of 0.63% per month.


Shanghai Composite (SSE) Monthly Return Distribution, Since 1990

Chart showing Shanghai Composite Monthly Return Distributions, Since 1990

On the opposite end of the spectrum is the Australian ASX. The ASX has the most left skewness of all the indices, with an average monthly return of 0.58% and median monthly return of 1.01% since 1970.


Australian Stock Exchange (ASX) Monthly Return Distributions, Since 1970

Chart showing Australian Stock Exchange (ASX) Monthly Return Distributions, Since 1970

In the end, the BSVA in Brazil, the Shanghai Composite in China, and, to a lesser extent the ASX in Australia just have too much skewness in their returns to validate the Sharpe Ratio as an appropriate measure for their risk-adjusted performance. As a consequence, metrics that account for skewness in returns may be better gauges in these markets.

Of the other indices, seven had fairly symmetrical distributions and five had moderately skewed ones. All told, this suggests that the Sharpe Ratio still has value as a performance metric and that it may not be as obsolete or ineffective as its critics contend.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/NPHOTOS


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Derek Horstmeyer

Derek Horstmeyer is a professor at George Mason University School of Business, specializing in exchange-traded fund (ETF) and mutual fund performance. He currently serves as Director of the new Financial Planning and Wealth Management major at George Mason and founded the first student-managed investment fund at GMU.

Katherine Vargas Medina

Katherine Vargas Medina is a current senior at George Mason University, double majoring in finance and management information systems. After graduation, she plans to continue her education by pursuing a master’s of science in finance. She is currently a finance intern at Cresset Capital, wealth management firm. She is interested in pursuing a career in wealth management and financial technology.

Lincoln Berkson

Lincoln Berkson graduated from the George Mason University School of Business in May 2022 with concentrations in finance and management information systems. He is a former member of the Montano Student Managed Investment Fund. Berkson recently accepted an offer from Accenture Federal Services and will be starting as a client financial management analyst at the end of June.

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