Comparing Sharpe Ratios Across Market Cycles for Hedge Fund Strategies

Abstract

Risk-adjusted criteria have been traditionally used to measure the performance of a hedge fund, and Sharpe ratio can be considered one of the most popular measures that determine its efficiency in terms of volatility. Although Sharpe ratio provides a standardised performance measurement criterion, it is not particularly effective in all market conditions which causes a doubt in its credibility as a comparative instrument. In this study, the Sharpe ratio is analyzed in terms of application in the different market cycles starting with application in the market during expansion, contraction and the crises. Using information available to past empirical studies, the analysis underlines the stability and fluctuation of Sharpe ratios across strategy classes phrases such as, trend-following, equity long-short, and fund of funds. The results indicate that although some strategies are characterized with consistent resilience, some strategies have been shown to have a pronounced cycle dependence especially in the high volatility periods. Besides, the paper discusses the criticisms of the deficiencies of the Sharpe ratio, such as the fact it fails to incorporate higher-moment risks and the presence of non-normal distributions of returns, and places it in the context of related discussion on the generic critique of hedge fund performance. The inclusion of the comparative view cites the research with the importance of complementary measures of performance; the Omega and Treynor ratio that include multi-dimensional risk and returns. One can infer that performance measures should be less static in portfolio management (cycle-conscious), and additional research should enhance the evaluation framework in order to achieve higher predictive ability and better investing decisions.