Nobel laureate Bill Sharpe is worried about what's being done with his famous ratio. You should be, too.

By Hal Lux
October 2002

In finance, a business that revolves around intricate calculations, few equations appear to have stood the test of time as well as the straightforward Sharpe ratio.

Mathematically simple but intuitively profound, the ratio gives investors a way to gauge how much return they can expect to reap for each unit of risk they take in any investment -- stock, bond, mutual fund or hedge fund -- and then to compare this telling number from one investment to another. The higher the ratio, the better: the more return for the risk.

The math is Finance 101: Take the expected return on an investment, subtract the "risk free" rate of return of Treasury bills, and divide the remainder by the standard deviation of the returns. QED: You've got a Sharpe ratio. A former Stanford University finance professor, William Sharpe, came up with the concept almost 40 years ago.
Professional and savvy amateur investors alike rely on Sharpe ratios as an essential tool in making portfolio decisions. Pension plans and consultants use them to pick money managers. California Public Employees' Retirement Systems, the largest pension fund in the U.S., regards the Sharpe ratio as the baseline measure for calculating risk-adjusted returns. Credit Suisse Asset Management offers its institutional and high-net-worth clients up-to-date Sharpe ratios online. Morningstar publishes Sharpe ratios for each of the 15,000 mutual funds it covers worldwide. Mutual Funds magazine gives its "best of class" awards only to the funds with the highest Sharpe ratios in their investment categories. And last month the Hong Kong Securities and Futures Commission released proposed guidelines for hedge fund reporting that recommend Sharpe ratios.....