Interview With a Trading Legend - Mercenary Trader

Interview With a Trading Legend
Page 27 of 38
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Part VII: Debunking the Sharpe Ratio
In Part VI of this series, we heard about Peter’s experiences running money for Commodities Corp, as
well as his methods for evaluating other traders and creating superior composite performance.
In Part VII we uncover the serious flaws in the Sharpe Ratio, a popular performance metric, and talk
about why it is so problematic. We also discuss the difference between managed futures and mutual
funds, advice for new traders, and more on the “upstream swim against human nature.”
JACK SPARROW: On the subject of evaluating trader performance: There is a very popular method
known as the Sharpe Ratio. We know from previous discussions that you’re not a big fan of that
measure.
PETER BRANDT: I hate the Sharpe Ratio. I think it is not only worthless for evaluating futures traders,
but it actually can be detrimental to the search.
JACK SPARROW: Given that the Sharpe Ratio is so popular, how about sharing as to why you dislike
it so much.
PETER BRANDT: The Sharpe Ratio gives the highest marks to traders who basically have the same
rate of return each and every month. And so, if a trader does 24% in a year, the way to get a great
Sharpe Ratio would be to spread that out at 2% a month. The Sharpe Ratio will reward a trader for
that because he has very little difference from month to month. It’s a measure of standard deviation
from the norm. People who use the Sharpe Ratio calculate an average and then look at the deviations
from that. And a trader gets penalized by the Sharpe Ratio for not having consistently equal months.
But for me there’s no difference between, say, a trader that does 2% every month, and a trader that
does 12% in two months, but doesn’t do anything in the other ten. The latter to me is a perfectly
acceptable way to trade, and in some ways I even like that trading result better.
JACK SPARROW: And the trader who has “steady eddie” returns of the same size every month –
that’s kind of the Bernie Madoff profile, or someone who is collecting naked options premiums. That
artificial level of stability is a little frightening.
PETER BRANDT: Exactly. You wonder where the performance is coming from, and you have to take a
look at how they are trading. If there are any question marks as to where the performance is coming
from – like if they are selling options – you have a chance for a disaster year, where traders did great
for a number of years but then didn’t account for a big event. And the big event grabs them.
Whereas the guy who does minus one, plus one and so on, and then has a really big month… that to
me is a trader who really knows how to manage risk and exploit opportunities when they come, and in
the meanwhile he’s waiting in the weeds. The Sharpe Ratio will brutalize that trader!
JACK SPARROW: Because the Sharpe Ratio fails to distinguish between upside volatility and
downside volatility, and thus penalizes upside volatility in periods of true opportunity.
PETER BRANDT: Exactly – upside volatility is penalized if it skews away from the norm. It is
interesting to me that the marketing people and the packagers of CTAs pay so much attention to a
ratio that I think is not a good ratio to follow.
JACK SPARROW: Why do you think the Sharpe Ratio is popular? Would you agree it is because
people crave stability to a greater degree than is healthy? That they aren’t willing to embrace the
uneven nature of the market process in generating returns?
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