Does the Measure Matter in the Mutual Fund Industry?

A frequent comment is that investment funds with a nonnormal return distribution cannot be adequately evaluated by using the classic Sharpe ratio. Research on hedge fund data that compared the Sharpe ratio with other performance measures, however, found virtually identical rank ordering by the various measures. The study reported here analyzed a dataset of 38,954 funds investing in seven asset classes over 1996–2005 and found that the previous result is true not only for hedge funds but also for mutual funds investing in stocks, bonds, real estate, funds of hedge funds, commodity trading advisers, and commodity pool operators. In short, choosing a performance measure is not critical to fund evaluation and the Sharpe ratio is generally adequate.The Sharpe ratio measures the relationship between the risk premium (mean excess returns) and the standard deviation of the returns generated by a portfolio, asset, or fund. Hedge funds and other alternative investments are prone to generating returns that have nonnormal distributions. For this reason, a number of researchers have claimed that these funds cannot be adequately evaluated by using the Sharpe ratio. Consideration of this issue has led to the development of numerous new performance measures, including Omega, the Sortino ratio, the Calmar ratio, and the modified Sharpe ratio, all of which are currently being debated in hedge fund literature. Recent research was carried out to compare these new performance measures with the Sharpe ratio by using return data on 2,763 hedge funds. Despite significant deviations of hedge fund returns from a normal distribution, the Sharpe ratio and the other performance measures resulted in virtually identical rank ordering of the hedge funds. These researchers analyzed only hedge funds, however, and thus did not consider whether this result is also true for funds investing in other asset classes.The aim of the study reported here was to address this issue. Combining two large data sets, I analyzed the rankings generated by various performance measures for 38,954 investment funds for the 1996–2005 period. This empirical study investigated 11 performance measures: the Sharpe ratio, Omega, the Sortino ratio, Kappa 3, the upside potential ratio, the Calmar ratio, the Sterling ratio, the Burke ratio, the excess return on value at risk, the conditional Sharpe ratio, and the modified Sharpe ratio. I found that the earlier research result is robust in regard to a large number of asset classes, including stocks, bonds, real estate, hedge funds, funds of hedge funds, commodity trading advisers, and commodity pool operators. This finding has serious implications for performance measurement in the investment industry. From a practical point of view, the Sharpe ratio is adequate for analyzing hedge funds and mutual funds. This finding is in accord with other research findings that, despite some undesirable features, the Sharpe ratio is adequate for analyzing performance throughout the investment industry.