Sharpe Ratio
The Sharpe ratio measures risk-adjusted return by dividing excess return over a risk-free rate by return volatility.
Allocator relevance: Useful for comparing liquid strategies’ efficiency—helps evaluate diversifiers and risk budgets beyond raw returns.
Expanded Definition
Sharpe ratio is most meaningful for strategies with frequent pricing and relatively stable volatility estimates (public markets, hedge funds). It is less reliable for private assets due to lagged marks and artificially low measured volatility. Also, Sharpe penalizes upside and downside volatility equally, which may not match allocator preferences.
Allocators use Sharpe alongside drawdown and scenario analysis, especially for diversifier sleeves.
How It Works in Practice
Teams compute Sharpe over consistent time horizons, compare to benchmarks, and check stability across regimes. They also examine whether returns are driven by hidden leverage or concentrated bets.
Decision Authority and Governance
Governance defines which metrics matter by portfolio role. Risk budgets often use Sharpe-informed assessments for allocating risk to liquid sleeves.
Common Misconceptions
- High Sharpe means low risk.
- Sharpe works the same for private markets.
- Sharpe alone captures tail risk.
Key Takeaways
- Sharpe is a risk-efficiency metric, not a safety guarantee.
- Best for liquid strategies with reliable volatility.
- Pair with drawdown and scenario analysis for allocator decisions.