Transcript
Matt Kaplan: Can you talk about Sharpe Ratios? What do you think is realistically achievable versus the common perception?
Eric Crittenden: We all want a high risk-adjusted return and the Sharpe Ratio is one way of trying to estimate the risk-adjusted return. It's basically just your compounded annual return minus the risk-free rate divided by the volatility of your return. It's basically excess returns divided by how volatile are those excess returns. It's not the best metric out there, but it's been around a long time and it's widely accepted as a universally applicable way to evaluate the risk-adjusted return of something so people want the highest Sharpe Ratio possible.
What I've found in the past 25 years is that there's a huge gulf between reality and perception. It's enormous and it's consistent meaning that there's just a massive belief system out there that's just fundamentally false. Everyone thinks that a Sharpe Ratio of 1.0 is okay and that a Sharpe Ratio of 2.0, is like a B, grade on a report card, and that over 2.0 is when you're doing really well and you're getting closer to having an A in the class. But if you collect data on every manager that's ever existed, every mutual fund, SMA, ETF, hedge funds, UCITs, CITs, all of them. It's almost impossible to find someone who's maintained a Sharpe Ratio greater than 1.0.
My philosophy, and what we do here at Standpoint is trying to find sources of return that are realistic and sustainable, that mix together well.
We could simplify it like this, we could say there's two different ways to try to get a Sharpe Ratio of 1.0. The first one would be to concentrate on an asset class and try to become an expert in that asset class, and simply be better than everyone else. You focus just on tech stocks, or you focus just on commercial real estate or small cab value or something and you try to be better than everyone else in the world at that. If you can pull that off, there's a chance that you'll have the Sharpe Ratio that you want but that's going to be a lonely place. I've never seen anybody sustain pole position or first place in a category for an extended period of time. That to me is intuitive and it seems like a good idea, but empirically it's a disaster. Very few people have been able to pull that off, if any, actually, none come to mind.
The second approach which sounds more complicated, but it's not, and it actually works a lot better is diversifying. Go find sustainable strategies that have low, but real reliable Sharpe Ratios of say 0.3 or maybe even 0.4, but make sure that each one of those individual strategies or asset classes is unrelated to the other ones. Something magical happens when you combine strategies or asset classes that are not redundant with one another.
They don't all lose money at the same time. They don't all have large gains at the same time. When you do that, you can take two different asset classes, both of which have a Sharpe Ratio of 0.3, pull them into the portfolio, and your portfolio can have a Sharpe Ratio of 1.0, simply because those two asset classes are both making money, but the pistons aren't moving together, they're not going up and down at the same time, they're offsetting each other.
That is how you could potentially, and more realistically achieve a Sharpe Ratio, maybe not of 1.0, but greater than what other people are experiencing. But it's not very exciting to people, and it's not very intuitive at first, but nothing about portfolio management or the mathematics of portfolio management is intuitive at first.
