The industry standard for measuring risk-adjusted returns, the Sharpe ratio, is “easily manipulated” and masks the fact that active managers are underperforming their benchmarks, according to UTS.
A joint academic paper by University of Technology Sydney (UTS) and the University of Maryland has called into question the efficacy of the Sharpe ratio and its role in measuring risk-weighted returns.
The paper, co-authored by UTS researcher and former Barclays/UBS investment banker John Crosby, proposes an alternative tool for measuring investment performance that suggests hedge funds and active strategies often underperform the market.
"We found that hedge funds generate returns that, after adjusting for risk, are significantly lower than index funds. Many active management strategies also underperformed, often to a dramatic extent," Mr Crosby said.
The problem with the Sharpe ratio, Mr Crosby said, is that it fails to take into account issues such as opaque strategies and short performance histories – adding that it can be "easily manipulated".
"Hedge funds in particular lack transparency – investors are not always privy to changes in strategy that increase risk, such as increasing leverage, or the use of exotic investment products such as collateralised debt obligations or credit default swaps," he said.
He cited Long-Term Capital Management, a US hedge fund backed by Nobel prize-winning economists, as an example.
"That fund lost more than $4 billion of investor’s money in a couple of months due to high leverage strategies," Mr Crosby said.
"Other hedge fund tricks include starting multiple funds and then only promoting those that achieve high returns in the short-term, to woo investors. This is why a reliable performance history matters."
The performance measure favoured by the researchers, known as MAP, takes into account "account ambiguity aversion" – that is, investors' preference for risks with known probabilities over risks with unknown or vague probabilities.
"We found that there can be – and often was – a very low correlation between our new measure and the Sharpe ratio, so the two measures are distinct from an economic point of view," Mr Crosby said.
"Put differently, our new performance measure is capturing a different dimension of risk and reward ... The bottom line is, using our new measure, all [active strategies measured] underperformed the market, or at most broke even. Interestingly, some had quite high Sharpe ratios.
"Investors are better off putting their money in low-cost index funds that simply track a broad-based equity index."
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