What is Sharpe Ratio?
It's a measure of an invesetment's risk-adjusted performance, calculated by comparing its return to that of a risk-free asset.
The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance. A negative Sharpe ratio means the risk-free or benchmark rate is greater than the portfolio’s historical or projected return, or else the portfolio's return is expected to be negative.
Sharpe Ratio's assumptions and limitations:
- The ratio's utility relies on the assumption that the historical record of relative risk-adjusted returns has at least some predictive value.
- The Sharpe ratio can be manipulated by portfolio managers seeking to boost their apparent risk-adjusted returns history. This can be done by lengthening the return measurement intervals, which results in a lower estimate of volatility. For example, the standard deviation (volatility) of annual returns is generally lower than that of monthly returns, which are in turn less volatile than daily returns. Financial analysts typically consider the volatility of monthly returns when using the Sharpe ratio.
- Calculating the Sharpe ratio for the most favorable stretch of performance rather than an objectively chosen look-back period is another way to cherry-pick the data that will distort the risk-adjusted returns.
Reference: https://www.investopedia.com/terms/s/sharperatio.asp