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The Sharpe ratio's market climate bias: Theoretical and empirical evidence from US equity mutual funds

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Abstract

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.

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Notes

  1. We assume that the market is relatively μ-σ-efficient with respect to the fund's investment universe; see Grinblatt and Titman (1989).

  2. This also applies to the funds we study empirically in Section ‘Empirical relevance of the market climate bias’. Each fund has a positive market risk exposure, in the total evaluation period as well as in each of the rolling windows we analyse.

  3. Instead of long-term estimates, an investor could also use the mean and standard deviation of market excess returns she expects during her planned investment period. This does not affect further results.

  4. As asset allocations of funds differ, rankings according to the SR and the DSR are usually not identical in the multi-factor case.

  5. These are the codes CA (capital appreciation), EI (equity income), G (growth), GI (growth income), MC (mid-cap) and SG (small growth).

  6. The survivorship bias is studied in detail by Brown and Goetzmann (1995), Elton et al (1996), Carhart et al (2002) and Rohleder et al (2011).

  7. All return observations that are larger than 100 per cent in absolute value were excluded.

  8. Next to the analysis of equity funds, these approaches are also used to measure the market timing of hedge funds. See, for example, Gregoriou et al (2002), Gupta et al (2003) and Chen and Liang (2007).

  9. The tests are based on heteroscedasticity and autocorrelation consistent standard errors according to Newey and West (1987).

  10. We also tested for simultaneous timing activities in several market factors along the lines of Chan et al (2002) and Comer (2006) and find no evidence of such activities.

  11. We thank Ken French for providing this data online under www.mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

  12. This follows from the necessity of an active portfolio to deviate from the efficient market portfolio in order to be able to disclose performance; see Treynor and Black (1973).

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Acknowledgements

Parts of this research were done while Marco Wilkens was visiting the Australian Graduate School of Management, University of New South Wales. He thanks Timothy Devinney and the academic and administrative staff for their hospitality and support. We are grateful to participants at research seminars at the University of Eichstätt-Ingolstadt; the University of Essex; the University of Melbourne; the University of New South Wales; the University of New Zealand; the University of Regensburg; the University of Tasmania; the University of Western Australia; the 46th Southern Finance Association Annual Meeting 2006, Destin; the 36th Annual Meeting of the Financial Management Association International 2006, Salt Lake City; the 15th European Financial Management Association Annual Meeting 2006, Madrid; the 68th Association of University Professors of Management Annual Meeting 2006, Dresden; the 9th Conference of the Swiss Society for Financial Market Research 2006, Zurich; the International Scientific Annual Conference Operations Research 2005, Bremen; and, especially, to Vikas Agarwal, Jerry Coakley, Klaus Eberl, Oliver Entrop, Norris L. Larrymore, Christoph Memmel, Stewart Myers and Marco Pagani for helpful comments and suggestions on earlier drafts of this article.

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  1. Finance and Banking, Friedrich-Alexander-University Erlangen-Nürnberg, Nürnberg, 90403, Germany

    Hendrik Scholz

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  1. Sebastian Krimm
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Krimm, S., Scholz, H. & Wilkens, M. The Sharpe ratio's market climate bias: Theoretical and empirical evidence from US equity mutual funds. J Asset Manag 13, 227–242 (2012). https://doi.org/10.1057/jam.2012.11

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