Does the Sharpe ratio matter?

SINGAPORE (May 8): In finance, as in many other aspects of life, a little knowledge is a dangerous thing. What seems intuitive and obvious may quite easily lead you down the wrong path, and what is common may not necessarily be useful for investment decision-making.

A case in point: the Sharpe ratio, the most commonly quoted measure of risk-adjusted returns in the fund management industry. The Sharpe is reported in most fund and ETF fact sheets; investment platforms such as Fundsupermart.com report it on their fund selector performance tables, as if it were a key criterion to be considered when deciding on a fund to invest in. In fact, some investors go so far as to choose funds based on which has the highest expected Sharpe ratio, on the basis that it should have the highest risk-adjusted returns. This can be dangerous and misleading if done indiscriminately.

On the surface, deciding on an investment based on risk-adjusted returns seems like it should make sense. After all, we invest based not only on potential reward but also the uncertainty of the reward. An investment with a higher potential return may not always be more attractive if it comes with greater risk. Thus, a metric that takes that risk into account is helpful in deciding where to invest.

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