Sharpe Ratio

Definition

The Sharpe ratio evaluates how much return a strategy generated per unit of volatility, typically relative to a risk-free rate. It is a standardized way to compare strategies with different volatility profiles, but it depends heavily on the quality of return data and assumptions about volatility. Allocator Context Allocators use Sharpe ratio as a screening tool, not a verdict. It is more informative for liquid strategies with frequent pricing and less reliable for illiquid strategies where valuations are smoothed and volatility is understated. Institutions often pair Sharpe ratio with drawdown, stress behavior, and qualitative risk controls before making decisions. Decision Authority Investment teams may reference Sharpe ratio in diligence memos, but committees typically want context: What drove the returns? Was volatility artificially low due to illiquid marks? Was leverage used? Committees tend to distrust Sharpe ratios that look “too clean” without clear explanation. Why It Matters for Fundraising Managers should present Sharpe ratio carefully and with supporting risk context. Strong Sharpe without transparency can backfire. The allocator’s goal is not a high Sharpe number—it is confidence that risk is understood and governed. Key Takeaways Useful for comparing liquid strategies Less reliable for illiquid or smoothed valuations Needs context: leverage, liquidity, drawdowns Best used alongside stress and downside analysis