EIM

Economics & Investment Management

The Sharpe Ratio and Negative Excess Returns:

The Problem and Solution
by

John E. Grable, PhD

Swarn Chatterjee, PhD

Abstract: The purpose of this issues

column is to review the use of a
widely used risk-adjusted portfolio
performance measurethe Sharpe
Ratio. This is a fundamental topic,
and for some readers this may be a
basic review; on the other hand, we
believe that this review might be of
interest to those who are still trying to
make sense of portfolio returns that
include significant losses resulting
from the deep market losses experienced during the Great Recession.

The purpose of this issues column

is to review the use of a widely used
risk-adjusted portfolio performance
measurethe Sharpe Ratio (SR). This
topic may seem a bit humdrum and
basic, and for some readers this might
be the case; on the other hand, we
believe that this review might be of
interest to those who are still trying to
make sense of portfolio returns that
include significant losses resulting from
the deep market losses experienced
during the Great Recession.
As a reminder, Sharpe (Sharpe
1966, 1994) originated the calculation
for what has since been termed the SR.
The SR provides a means to compare
portfolio performance on a riskadjusted basis. The SR can be computed as follows:
SRi = (ui rf ) /si
This issue of the Journal went to press
in April 2014. Copyright 2014,
Society of Financial Service Professionals.
All rights reserved.

where,
SRi = Sharpe Ratio of portfolio
ui = average return of portfolio
rf = risk-free rate of return
si = standard deviation of the excess
portfolio return
Two aspects of the SR are apparent. First, the measure of risk (volatility) is standard deviation, which
implies the evaluation of total, rather
than systematic, risk. Second, the SR
indicates the level of return per unit of
risk taken. The SR of a portfolio is
indicated by the slope of a line from
the risk-free rate to the point of portfolio return (Scholz and Wilkens 2005).
Holding other factors constant, the
higher the SR, the better the performance. In effect, the SR standardizes
returns so that multiple portfolios can
be compared.
The use of SRs is widespread
within the financial service profession.
Nearly every fund and asset management rating service reports the SR of
funds and managed accounts. Financial
advisors use these figures to compare
the risk-adjusted performances of portfolio managers. Practically speaking,
this is the primary use of such ratios
namely, to rank order investment portfolios. A secondary use of the SR is as
an input into other measures of portfolio performance. For example, the Msquared measure, which was developed
by Modigliani and Modigliani
(Modigliani and Modigliani 1997),
utilizes the SR as a formula input.
On the surface, the SR formula
seems straightforward. Nearly every

financial advisor already understands

the basic calculation and how to use
the ratio in the portfolio development, implementation, and review
process. Recently we ran into a perplexing problem using the SR. Given
our situationwhich is described
belowwe wanted to take time in
this column to help others better
understand a particular nuance associated with the ratio.
Not long ago, we were reviewing
the performance of two managed
accounts. It is important to put the
analysis into context. The returns being
analyzed included data from the Great
Recession, which resulted in heavily
skewed negative returns. Here are the
SR data inputs for the two accounts:
Portfolio A
ui = -20.93 percent
si = 161.80 percent
rf = 3.50 percent average over
period
Portfolio B
ui = -24.24 percent
si = 182.69 percent
rf = 3.50 percent average over
period
It should be obvious that Portfolio
A provided a superior return over the
period. The nominal performance difference was 3.31 percent. Additionally, the
standard deviation of returns was lower
for Portfolio A. As is common practice in
the financial service field, we wanted to
confirm that Portfolio A also provided a
better return on a risk-adjusted basis.
Turning to the SR, we calculated the following for the two portfolios:

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ECONOMICS & INVESTMENT MANAGEMENT

Portfolio A: SRi = -0.151

Portfolio B: SRi = -0.152
Does this seem odd? The results
certainly caught us off guard.1 We
were perplexed by this result until we
remembered a crucial point about the
SR. Specifically, the SR becomes very
unstable during times of market
decline. Recall that the performance
of the two portfolios was measured
during one of the worst bear markets
in history. It was not surprising that
both accounts lost money; nor was it
surprising that the standard deviation
of returns was so large. What was
unexpected was how close the SR outcomes were to each other. Conceptually, it is not possible for the riskadjusted performance of Portfolio B
to be within .001 of Portfolio A. No
sensible investor would even consider
Portfolio B over Portfolio A, given the
return and standard deviation information presented.
It turns out that the SR will frequently provide a biased result when
negative excess returns (ui rf ) are
present (Israelsen 2005). When faced
with this type of situation, financial
advisors need to make a modification
to the SR. The modified SR formula is
shown below:
ERi
absERi
)
SR'i = ERi / (si
where,
SRi
= modified Sharpe Ratio
ERi = excess return of portfolio,
were ERi = ui rf
absERi = absolute value of excess
return of portfolio
si
= standard deviation of the
excess portfolio return
Ranking of portfolios using either
the SR or the modified SR will be
exactly the same when expected returns
are positive; however, in situations

where the excess return is negative, the

rankings may be significantly different. The change in SR when the modification is made results from the fact
that the result of ERi will always
absERi
be -1.0, at least when negative excess
returns are persistent. As illustrated
below, the modified SR is markedly
different from the traditional SR outcome for the two accounts.
Portfolio A: SR'i = -0.3952
Portfolio B: SR'i = -0.507
While the absolute ranking of the
two portfolios did not change, the
magnitude of the ranking shifted dramatically after using the modified SR
formula. In effect, making the adjustment to the exponent in the denominator normalized the risk-adjusted
return calculation to account for the
presence of negative excess returns.
The key takeaway is this: remember that the SR may give a counterintuitive indication of risk-adjusted performance when the portfolios being
compared have negative excess returns.
In these situations it is always a good
idea to use the modification to the SR
formula as described here. The outcome will be a more realistic estimate
of the level of return per unit of risk
taken. A second takeaway is that those
advisors who also use the Treynor
Ratio when comparing diversified
portfolios and accounts should consider making the same type of adjustment when negative excess returns are
present. The only difference between
the SR and the Treynor Ratio is the
use of beta (b) in the formulas denominator. Hopefully, moving forward,
financial advisors will not need to use
a modified SR formula, but if the markets ever do sustain another signifi-

cant bear trend, remembering this simple adjustment may help clarify portfolio comparisons.
Dr. John E. Grable holds an Athletic Association Endowed Professorship at the University of Georgia, where he conducts
research and teaches financial planning. Dr.
Grable is best known for his work related to
financial risk tolerance assessment and psychophysiological economics. He serves as
the Co-Director of the Financial Planning
Performance Laboratory at UGA. He may
be reached at grable@uga.edu.
Dr. Swarn Chatterjee is an Associate Professor of Financial Planning at the University of Georgia. He has published more
than 40 peer-reviewed papers and teaches
classes in investing, portfolio management, and behavioral finance. He serves
as the Co-Director of the Financial Planning Performance Laboratory at UGA. He
can be reached at swarn@uga.edu.

(1) The problem can be seen with even more

clarity if the standard deviations are reduced
to, say, 62 percent and 83 percent for Portfolios
A and B, respectively. The traditional Sharpe
Ratio results in an output of -0.39 for Portfolio
A and -0.33 for Portfolio B. These results lead
to the incorrect conclusion that Portfolio B is
superior to Portfolio A.
(2) This result was obtained in Excel as follows:
(-.2093 - .035)/(1.618^-1).
References
Israelsen, C. (2005). A Refinement to the Sharpe
Ratio and Information Ratio. Journal of
Asset Management 5(6): 423-427.
Modigliani, F. and Modigliani, L. (1997). RiskAdjusted Performance. The Journal of
Portfolio Management 23(2): 45-54.
Scholz, H. and Wilkens, M. (2005). A Jigsaw
Puzzle of Basic Risk-Adjusted Performance Measures. The Journal of Performance Measurement Spring: 57-64.
Sharpe, W. F. (1966). Mutual Fund Performance. Journal of Business 39(1): 119-138.
Sharpe, W. F. (1994). The Sharpe Ratio. Journal
of Portfolio Management Fall: 49-58.

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