At a recent investment team meeting, I commented that all of our portfolios have great Sharpe ratios on a 1 year time frame. The other members on the team could hardly contain their joy when they heard the news. Although, with all due respect to other investment nerds out there, I think the majority of people in this world would come back with the reply, ‘What’s Sharpe?’ Well, William Sharpe was a Nobel laureate in Economic Sciences who developed the Sharpe ratio to measure risk-adjusted performance. The formula for the ratio is simply the portfolio return minus the risk free rate (we use 6 month treasury bills) divided by the standard deviation of the portfolio. This ratio will then tell us if the portfolio’s returns are due to smart investments or undue risk, which I would argue becomes very important in this market environment.
Actually, Goldman Sachs would back up that claim as well. In their ‘best ideas for 2010’ they recommend buying ‘High Sharpe Ratio Stocks’. They studied high Sharpe stocks back to 1999 and found that they offer a strong track record against the S&P 500. So let’s see how Pinnacle has done on the 1 year time frame.
Pinnacle portfolios had a Sharpe ratio that was between 3.5 and 3.7. We then looked at other Sharpe ratios in the investment world to see if this was a good number or not for the past year. We started with the SPY (S&P 500 SPDRs) and found a Sharpe ratio of 2.56. Next, we found the Sharpe for well known diversified mutual funds: American Balanced had a Sharpe of 3.02, Dodge and Cox Balanced had a Sharpe of 3.15, and Leuthold Core had a Sharpe of 2.14. Finally, we found the Sharpe of XME (Metals and Mining ETF that performed very well over the last year) to be 2.82.
When looking at the risk adjusted Sharpe ratio, it is very clear to us that we have been managing our portfolios due to smart investments, and not undue risk.
