“What is your Sharpe?” This is one of the first questions that is always asked of managers. The mangers will firmly reply, “My Sharpe ratio is X.” The conversation then moves onto the next question as if this one number serves to address the performance issue, yet the Sharpe ratio is dynamic. In a drawdown, no one wants to even see that number. When things are going well, the Sharpe ratio is king. Investors have to accept that this is a variable number because the underlying assets bought by funds have variable Sharpe ratios.
Investors may know that the Sharpe ratio for asset classes change, but research also shows that it is associated with swings in the business cycle. Most long-only managers will likely see their ratio ebb and flow with the business cycle. Hedge fund managers should see the same swings.
Now a dynamic Sharpe ratio may seem obvious. Returns fall and if fund volatility stays the same, the ratio will decline. What is more interesting is that the ratio is sensitive to changes in well-defined factors. Hence, the Sharpe ratio is predictable. This is the conclusion of some older work by Yi Tang and Robert Whitelaw, “Time-varying Sharpe Ratios and Market Timing“. They find that the Sharpe is very business cycle dependent with lows at the peak an highs at the trough. The Sharpe is predictable through tracking some macro variables.
We bring this issue to your attention because if there is a decline in the Sharpe ratio for equities, it will generally spill-over to asset managers and make it harder for them to achieve a high Sharpe ratio. This will be especially the case for mangers who are long-only or don’t diversify across many asset classes.
Global macro managers who trade across asset classes are more likely to have Sharpe ratios that have the potential to weather this effect. As important, the research suggests that the Sharpe ratio for asset managers can be improved through market timing. Hence, macro managers who can time exposure to equities using simple models can improve their Sharpe ratio versus a constant equity exposure.