How Sharpe Ratios Can Fail | Chief Investment Officer

Measuring returns relative to the risk taken may be inadequate and often misused in evaluating investments, asset classes, and managers, according to Aon Hewitt.

Risk-adjusted return metrics, including Sharpe ratios, “can only do so much and should be used along with other tools,” argued consultant Bob Penter.

While many risk-adjusted return measures aim to equate units of return to units of risk, this definition often goes against investment objectives of real return achieved by the investor, he continued.

“A high Sharpe ratio is inadequate if the returns are too low,” Penter wrote in a blog post. “Stated differently, you can’t ‘eat’ a Sharpe ratio.”

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Risk-adjusted returns also focus on annual or annualized returns, contrary to institutional investors’ long-term time horizons.

In addition, Penter wrote Sharpe ratios could lead to distorted comparisons of equities or hedge fund managers because they give credit to managers that reduce the portfolio’s market risk.

“An investor searching for a large cap US equity manager, for example, already has made an explicit choice to take on the risk associated with that asset class,” he said. “The investor has already allocated its risk budget to account for the market risk.”

The consultant also argued that while risk-adjusted returns for an asset or manager may look good on a standalone basis, the result is like to change in the context of a broader portfolio.

For example, a risk-oriented manager who has a Sharpe ratio of 0.32 may appear superior to the return-oriented manager with a Sharpe Ratio of 0.26. However, in a balanced portfolio with public equities and bonds, the return-oriented manager delivered a 0.4 Sharpe ratio, compared to the risk-oriented manager’s 0.37.

“The impact of two investments on the portfolio risk may be very different,” the consultant concluded, “depending on the other assets in the portfolio and the correlations of returns.”

Kentucky’s government employee pension is challenging legislation that would shift responsibility for governance and staffing decisions from the board of trustees to state government officials.

Kentucky Retirement Systems (KRS) executive director William Thielen spoke out against the bill—which the Senate has already unanimously passed—in a letter to the head of the house committee reviewing the legislation.

“Several provisions will make the systems less efficient, less competitive, and will result in the expenditure of additional funds,” Thielen argued.

The $18 billion Kentucky Teachers Retirement System also lobbied against the proposal, which has separate provisions regarding each of the two state pension funds.

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Several components of the bill concern transparency—fee and investment holding disclosure, specifically—which State Senator Joe Bowen, its sponsor, highlighted at a committee meeting in January.

“It’s a bill about transparency,” Bowen said. “It’s a bill about transparency in our government, it’s a bill about transparency in the subdivisions of our government, and, perhaps more than anything else, it’s a bill about transparency in those things that we fund as a government.”

But it is the legislation’s other demands that are troubling, said Thielen in an interview with CIO.

The Senate would have final approval over executive director and board member appointments, and state government a significant role in KRS’s hiring process, including the last word on staffing and promotion decisions.

“We’ve got our issues here and it’s hard enough attracting applicants,” Thielen said, referencing KRS’s status as one of the worst-funded pensions in the country.

Thielen, who announced his intention to retire last year, has already had to stay on longer than planned due to a lack of qualified applicants for his position. Requiring Senate confirmation of executive director appointments would make finding a replacement that much more difficult, and more politicized, Thielen said.

As for the provisions regarding fund personnel and their compensation, Thielen said the bill would “create significant problems for us attracting and retaining staff.” While KRS links employee compensation to performance, the bill would require adoption of the government’s tenure-based pay structure.

“It puts all the compensation decisions in the hands of the secretary of personnel instead of our trustees,” said Thielen. “We see it as usurping the board’s authority” in building and managing a team.

Stripping performance bonuses from investment staff members could also “push [KRS] into the hands of high-priced asset managers,” said Ashby Monk, a senior advisor at the University of California’s Office of the CIO and executive director of Stanford University’s Global Projects Center.

“You need to empower the board to have the ability to pool the resources it needs to achieve its objectives,” he said.

Other problematic portions of the bill, according to Thielen, are its requirements that KRS follow state procurement procedures for hiring managers and that all contracts be subject to review by a legislative subcommittee.

“Essentially the authority to revise contracts or even enter into contracts is given to the secretary of finance instead of our board, which hears all the information and sees all the proposals,” Thielen said.

Provisions regarding fee and holding transparency do also worry Thielen—but only because industry fee disclosure practices are not currently at the level that the bill would require.

“We are putting everything we have out there,” Thielen said, explaining that KRS already discloses fees by asset classes and reports returns as net of fees. “We just don’t want to be put in a position where we’re violating the requirement because we can’t get the information.”

Specifically, Thielen pointed to investments in private equity funds-of-funds as an area where KRS is not currently able to determine the costs of the underlying funds.

“We honestly believe we are among the most transparent pension funds in the country,” Thielen said. “This bill would seriously impact our operations and the cost of our operations.”