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Performance hypothesis testing with the Sharpe ratio: The case of hedge funds

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  • Auer, Benjamin R.
  • Schuhmacher, Frank

Abstract

As recent research highlights that the Sharpe ratio has a decision theoretic foundation even in the case of asymmetric or fat-tailed excess returns and thus is adequate even for the evaluation of hedge funds, this note provides the first Sharpe ratio based performance analysis of the hedge fund market. Furthermore, it addresses the important practical question whether the choice of hypothesis test used to statistically compare Sharpe ratios can influence an investor’s hedge fund selection process. Our key findings are as follows: (i) Only a small fraction of hedge funds in our large dataset can significantly outperform passive investments in corresponding hedge fund indices. (ii) Especially in the presence of autocorrelated or skewed excess returns, the traditional test of Jobson and Korkie (1981) and Memmel (2003) tends to overstate the number of significant outperformers and thus provides potentially misleading information for investors. Decision makers are advised to use the bootstrap test of Ledoit and Wolf (2008) allowing robust and more reliable inference.

Suggested Citation

  • Auer, Benjamin R. & Schuhmacher, Frank, 2013. "Performance hypothesis testing with the Sharpe ratio: The case of hedge funds," Finance Research Letters, Elsevier, vol. 10(4), pages 196-208.
    • Handle: RePEc:eee:finlet:v:10:y:2013:i:4:p:196-208
    DOI: 10.1016/j.frl.2013.08.001
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    3. Cheng Yan & Ji Yan, 2021. "Optimal and naive diversification in an emerging market: Evidence from China's A‐shares market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(3), pages 3740-3758, July.
    4. Auer, Benjamin R., 2014. "Daily seasonality in crude oil returns and volatilities," Energy Economics, Elsevier, vol. 43(C), pages 82-88.
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    6. José Claudio Isaias & Pedro Paulo Balestrassi & Guilherme Augusto Barucke Marcondes & Wesley Vieira da Silva & Carlos Henrique Pereira Mello & Claudimar Pereira da Veiga, 2021. "Project Portfolio Selection of Solar Energy by Photovoltaic Generation Using Gini-CAPM Multi-Criteria and Considering ROI Covariations," Energies, MDPI, vol. 14(24), pages 1-21, December.
    7. Benjamin R Auer, 2016. "Pure return persistence, Hurst exponents and hedge fund selection – A practical note," Journal of Asset Management, Palgrave Macmillan, vol. 17(5), pages 319-330, September.
    8. Rolando Gonzales Martinez, 2023. "Portfolio analysis with Sharpe ratios resampled with bootstrapping," Economic Analysis Letters, Anser Press, vol. 2(1), pages 23-28, March.
    9. Costanza Torricelli & Beatrice Bertelli, 2022. "ESG screening strategies and portfolio performance: how do they fare in periods of financial distress?," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) 0087, Universita di Modena e Reggio Emilia, Dipartimento di Economia "Marco Biagi".
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    More about this item

    Keywords

    Sharpe ratio; Hedge funds; Robust testing; Performance measurement;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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