Implications of Sharpe Ratio as a Performance Measure in Multi-Period Settings

Ali Lazrak, Jaksa Cvitanic () and Tan Wang
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Ali Lazrak: Sauder - Sauder School of Business [British Columbia] - UBC - University of British Columbia [Canada]
Tan Wang: Division of finance; China Academy of Financial Research (CAFR) - UBC - University of British Columbia [Canada]

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Abstract: We study effects of using Sharpe ratio as a performance measure for compensating money managers in a dynamic and frictionless market setting. First, we demonstrate that with such a performance measure, the manager's focus on the short horizon performance is detrimental to the investor's long horizon performance. Numerical experiments illustrate that when returns are iid, the performance loss is significant, even when the investor's investment horizon is not much longer than the manager's. When expected returns are mean reverting, the performance loss is exacerbated. Second, we show that Sharpe ratio maximization strategies tend to increase (decrease) the risk in the later part of the optimization period after a bad (good) performance in the earlier part of the optimization period. As illustrated by a simulation exercise, this prediction is in agreement with empirical observations, and it presents a rational expectations alternative to the prevalent tournament theory explanation.

Keywords: Sharpe Ratio; Performance Measures; Money Managers (search for similar items in EconPapers)
Date: 2008-05-01
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Citations: View citations in EconPapers (8)

Published in Journal of Economic Dynamics and Control, 2008, Vol.32, n°5, pp. 1622-1649

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Journal Article: Implications of the Sharpe ratio as a performance measure in multi-period settings (2008)
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