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Journal of Financial Econometrics Advance Access originally published online on December 8, 2008
Journal of Financial Econometrics 2009 7(2):152-173; doi:10.1093/jjfinec/nbn022
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© The Author 2008. Published by Oxford University Press. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org.

Estimation Risk-Adjusted Sharpe Ratio and Fund Performance Ranking under a General Return Distribution

Yong Bao
     Purdue University

Address correspondence to Yong Bao, Department of Economics, Krannert School of Mangement, Purdue Univeristy, West Lafayette, IN 47907, or e-mail: ybao{at}purdue.edu

JEL Classification: G11


  Abstract

We study the sample estimation risk of the traditional Sharpe ratio without the restrictive assumption of normality for return series. We derive analytical results for the approximate bias and variance of the sample Sharpe ratio in terms of the underlying distribution parameters. The results clarify several misinterpretations existing in the literature. A Monte Carlo study shows that our bias and variance formulae approximate the true moments of the sample Sharpe ratio remarkably well. We propose using the analytical results to design an estimation risk-adjusted Sharpe ratio. An empirical study of mutual fund performance shows that using the adjusted Sharpe ratio gives a quite different performance ranking of those traditionally top-ranked funds.

KEYWORDS: bias, nonnormality, Sharpe ratio, variance

The author would like to thank Eric Renault (the editor), two anonymous referees, Donald Lien, Wenlan Qian, Wenjuan Xie, and conference participants at the the 2008 Midwest Finance Association Annual Meeting (San Antonio) and the 2nd Risk Management Conference (Singapore) for very helpful comments. The author is solely responsible for all the remaining errors.

Received November 13, 2007; revised August 20, 2008; accepted November 10, 2008


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