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Re-Evaluating Sharpe Ratio in Hedge Fund Performance in Light of Liquidity Risk

Author

Listed:
  • Richard Van Horne

    (Poznan University of Economics and Business Institute of Finance, Department of Investment and Financial Markets)

  • Katarzyna Perez

    (Poznan University of Economics and Business Institute of Finance, Department of Investment and Financial Markets)

Abstract

This paper demonstrates how the Sharpe Ratio can be modified by altering the measure of “total risk” in the denominator of the Sharpe Ratio (i.e., the standard deviation) to include liquidity risk, a major risk for investors in hedge funds that is missing from the standard Sharpe Ratio formulation. We refer to our liquidity-risk-adjusted performance ratio as the LRAPR. The results of our analysis of 1186 hedge funds alive in 2012–2020 show that funds with higher liquidity risk exhibit higher Sharpe Ratios and higher Alphas (as estimated in a 7-factor model that does not incorporate liquidity risk). We posit that analysts and investors should not necessarily take these higher Sharpe Ratios and higher Alphas as indications of fund superiority; what appears to be superior manager skill may rather be a compensation for bearing liquidity risk. Our LRAPR is a tool that analysts or investors could use to compare funds on a more equal footing, adjusting for differential liquidity risk across funds.

Suggested Citation

  • Richard Van Horne & Katarzyna Perez, 2021. "Re-Evaluating Sharpe Ratio in Hedge Fund Performance in Light of Liquidity Risk," Journal of Banking and Financial Economics, University of Warsaw, Faculty of Management, vol. 2(16), pages 91-103, December.
    • Handle: RePEc:sgm:jbfeuw:v:2:y:2022:i:16:p:91-103
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    File URL: https://jbfe.wz.uw.edu.pl/resources/html/article/details?id=227966
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    More about this item

    Keywords

    liquidity risk; liquidity risk factor; serial correlation; Sharpe ratio; hedge fund performance;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • C18 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Methodolical Issues: General

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