The Sharpe Ratio and the Information Ratio

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Andrew Roberts
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February 17, 2013

The article, “The Sharpe Ratio and the Information Ratio”, by Deborah Kidd is about the original risk-adjusted performance measure and they are Sharpe ratio and the Information Ratio. William Sharpe designed the first performance metric to insolate excess return per unit of total risk taken. The Sharpe ratio shows whether a portfolio's returns are due to smart investment decisions or a result of excess risk. The Sharpe ratio measure dividends average portfolio excess return over the sample period by the standard deviation of returns over that period. It measures the reward to volatility trade-off. The Information Ratio is a ratio of portfolio returns above the returns of a benchmark to the volatility of those returns. The information ratio divides the alpha of the portfolio by the nonsystematic risk of the portfolio. It measures abnormal return per unit of risk that in principle could be diversified away by holding a market index portfolio. There are two key points that the author was communicating to its’ readers. The first key point relates to the advantages and disadvantages of the Shape ratio. The second key point relates to the advantages and disadvantages of the Information Ratio.

The first key point is the advantages and disadvantages of the Sharpe ratio. A disadvantage of the Sharpe is that it is expressed as a raw number and the higher the Sharpe ratio is the better. Another disadvantage is that the Sharpe ratio only uses standard deviation when calculating the risk. So it would be awkward when calculating the Ratio for asymmetric returns. Another disadvantages of Sharpe’s ratio is that Sharpe ratio should not be used as a measure to compare portfolios because when there is a negative Sharpe ratio the risk increases. An advantage of the Sharpe ratio is that it can be easily calculated without needing any additional data regarding the asset’s profitability. Another advantage is that people can...
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