According to a University of Massachusetts professor, the key measure by which hedge funds sell market their performance actually tells investors little about potential risks they may be taking, says a recent Reuters report.
The Sharpe ratio is designed to measure risk-adjusted return. It is the difference between returns and a risk-free interest rate divided by the volatility or range of possible returns.
But to Nassim Nicholas Taleb, a hedge fund investor and a professor in the sciences of uncertainty at the University of Massachusetts Amherst, it is little more than a sophisticated pseudo-scientific marketing tool.
The Sharpe ratio has been used in recent years to convince investors that hedge funds offer fewer risks than traditional equity investments.
Taleb compares the ratio, and its reliance on volatility, to a horoscope. He goes so far as to call it a scam, saying it is something that a large number of people rely on, but is based on little hard scientific evidence. Taleb says volatility is not a good measure of risk.
The problem says Taleb, is that economics and finance are not solid sciences, and shouldn’t allow for the use of statistical tools, including the law of averages and the normal distribution to model returns.
Normal distribution is the theory that most outcomes will fall within a narrow range on both above and below the average or mean.
But the idea should only be applied to things like weight or height, where an extreme reading will not distort the mean if the sample of people is large and representative.
But in cases such as finance, where large losses and gains will continue to appear no matter how large the sample is, normal distribution cannot be applied.