By Nassim Taleb (Reuters, 23 July 2006)
The Sharpe ratio, a key measure of performance used by hedge funds to sell themselves, is flawed and tells investors nothing about the risks they are taking, Nassim Nicholas Taleb, a hedge fund investor and a professor in the sciences of uncertainty at the University of Massachusetts.
“It’s used for marketing. It looks sophisticated, but the volatility part is not a good measure of risk,”. “The Sharpe ratio is like a horoscope … A startlingly high number of people rely on this bogus theory … It’s a big scam by finance professors …” said Taleb in an interview earlier this week.
At the root of the problem is the assumption that economics and finance are solid sciences, which allows the use of statistical tools such as the law of averages and the normal distribution to model returns. Being normally distributed means that most outcomes will fall within a narrow range either side of the mean. But the idea can 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. It cannot be applied to exceptional extreme events in finance such as large losses or gains that will continue to dominate the picture no matter how large the sample gets.
“If the exception doesn’t matter in the long-run, then the law of averages applies … If the exception continues to dominate the sample even if the sample becomes very large, you can’t use the normal distribution,” Taleb said.
“It can’t be applied to socio-economic variables … An example is stock market returns … In the last 50 years, 10 days represented more than half of stock market returns.”
Hedge fund returns are another example. US-based Long Term Capital Management (LTCM) collapsed in 1998 in the wake of the emerging market crisis as liquidity dried up because of large trading losses using a model based on the law of averages.
“LTCM had lots of small up months and a few large down months,” Taleb said. “This is not detected by the Sharpe ratio as it assumes a symmetry in the distribution of returns.”