The Sharpe Ratio Can Oversimplify Risk

The Sharpe Ratio Can Oversimplify Risk:

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The Sharpe ratio is a good measure of risk for large, diversified, liquid investments, but for others, such as hedge funds, it can only be used as one of a number of risk/return measures.

Where it Doesn't Work Well
The problem with the Sharpe ratio is that it is accentuated by investments that don't have a normal distribution of returns. The best example of this is hedge funds. Many of them use dynamic trading strategies and options that give way to skewness and kurtosis in their distribution of returns. (For related reading, see A Brief History Of The Hedge Fund, Massive Hedge Fund Failures, Taking A Look Behind Hedge Funds and Losing The Amaranth Gamble.)

Many hedge fund strategies produce small positive returns with the occasional large negative return. For instance, a simple strategy of selling deep out-of-the-money options tends to collect small premiums and pay out nothing until the 'big one' hits. Until a big loss takes place, this strategy would show a very high Sharpe ratio. (For more insight, read Option Spread Strategies.)
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