The Sharpe Ratio's Market Climate Bias: Theoretical and Empirical Evidence from US Equity Mutual Funds
Journal of Asset Management, Vol. 13, No. 4, August 2012, pp. 227-242
1 Pages Posted: 26 Jan 2006 Last revised: 31 Jul 2012
Date Written: July 31, 2012
This article analyses the impact of market climates on the Sharpe ratios (SRs) of funds. On the basis of a common factor model, we derive analytically how market climates impact the SR – taking into account the abilities of fund managers. This applies especially to the mean of the market returns during the evaluation period: The performance of funds with relatively high unsystematic risk is biased upwards in outstandingly negative market climates, and vice versa. Our empirical study of US equity mutual funds supports these theoretical insights. We show that the SR of poorly diversified funds is biased upwards in bear markets, and vice versa. Subsequently, we confirm that actual fund SRs depend on especially the mean excess returns of the market. Thus, the SR does not provide a meaningful assessment of fund performance, especially in extraordinary times. We therefore suggest using the ‘normalised’ Sharpe ratio in future empirical research, in order to avoid the bias of SRs and rankings due to market climate.
Keywords: Performance evaluation, equity mutual funds, Sharpe ratio, bear market, market conditions
JEL Classification: G11
Suggested Citation: Suggested Citation