The Sharpe Ratio's Market Climate Bias: Theoretical and Empirical Evidence from US Equity Mutual Funds.
Bunnenberg S, Scholz H, Wilkens M (2012)
Publication Language: English
Publication Type: Journal article, Original article
Publication year: 2012
Journal
Publisher: Henry Stewart Publications
Book Volume: 13
Pages Range: 227-242
Journal Issue: 4
DOI: 10.1057/jam.2012.11
Abstract
This article analyses the impact of market climates on the Sharpe ratios (SRs) of funds. On the basis of a common factor model, we derive analytically how market climates impact the SR-taking into account the abilities of fund managers. This applies especially to the mean of the market returns during the evaluation period: The performance of funds with relatively high unsystematic risk is biased upwards in outstandingly negative market climates, and vice versa. Our empirical study of US equity mutual funds supports these theoretical insights. We show that the SR of poorly diversified funds is biased upwards in bear markets, and vice versa. Subsequently, we confirm that actual fund SRs depend on especially the mean excess returns of the market. Thus, the SR does not provide a meaningful assessment of fund performance, especially in extraordinary times. We therefore suggest using the normalised Sharpe ratio in future empirical research, in order to avoid the bias of SRs and rankings due to market climate. © 2012 Macmillan Publishers Ltd.
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APA:
Bunnenberg, S., Scholz, H., & Wilkens, M. (2012). The Sharpe Ratio's Market Climate Bias: Theoretical and Empirical Evidence from US Equity Mutual Funds. Journal of Asset Management, 13(4), 227-242. https://dx.doi.org/10.1057/jam.2012.11
MLA:
Bunnenberg, Sebastian, Hendrik Scholz, and Marco Wilkens. "The Sharpe Ratio's Market Climate Bias: Theoretical and Empirical Evidence from US Equity Mutual Funds." Journal of Asset Management 13.4 (2012): 227-242.
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