Failing to Build High Sharpe Ratio-Portfolios
A Sharpe ratio of 1 should be easily achievable, right?
- High Sharpe ratios are attractive given consistent returns
- However, the traditional 60/40 portfolio generated a Sharpe ratio of well below 1
- Achieving a sustainable 1+ Sharpe ratio is challenging
Maven Search, a headhunter, is currently looking for an experienced portfolio manager to run quantitative strategies at a multi-strategy hedge fund based in New York. The right candidate should have at least three years of trading experience, can code in Python and C+, has a Ph.D. or Master’s degree, and a track record with a 1.5+ Sharpe ratio.
Oxford Knight, another recruiter, is looking for “ambitious and driven PMs/Quants” that have a Sharpe ratio of at least 5 for another hedge fund. Essentially this means for a 10% return the annual volatility would only be 2%, which is not much at all considering that the S&P 500 often rises or falls by 2% per day.
Unfortunately, most investors do not have the flexibility and infrastructure of a multi-strategy hedge fund, so need to constrain themselves to simpler portfolios.
In this research note, we will explore if the average investor can achieve a Sharpe ratio of at least 1.
SHARPE RATIOS OF THE US STOCK MARKET
Almost all investors’ portfolios are dominated by exposure to the stock market, which typically reduces as investors age and need more certainty for their retirement. If someone had a 100% exposure to the stock market, what would have been the risk-adjusted returns?
We use returns from the Kenneth R. French data library and compute the Sharpe ratio for the U.S. stock market for each decade since 1930. We observe that the ratio ranged widely with three periods of slightly negative Sharpe ratios and one decade with a stellar ratio of 1.61 between 1950 and 1959, which reflects the economic recovery after World War II. However, the Sharpe ratio for the entire 90-year period was a mere 0.39.