How to Game Your Sharpe Ratio

Richard Spurgin
Clark University

Please Address Correspondence to:

Richard Spurgin
Assistant Professor of Finance
Clark University
Worcester, MA 01610
Email: rspurgin@clarku.edu
Office: 508-793-7596
Fax: 508-793-8822

How to Game Your Sharpe Ratio

Abstract

This article describes a derivative structure that can induce an upward bias in the measurement of
the Sharpe ratio. The structure accomplishes this by shifting returns from the highest monthly return each
year to the lowest one. This smoothes observed returns and lowers observed volatility without
significantly altering the annual return. The objective of the article is to demonstrate how adding
derivatives can appear to improve risk-adjusted return without actually doing so.

How to Game Your Sharpe Ratio

More and more managers are selected based on risk-adjusted, as opposed to absolute, performance.
A recent article (Coleman and Siegel, 1999) proposes compensating hedge fund managers based on riskadjusted return. A manager with a high Sharpe ratio will get a close look from institutional investors even
if the absolute returns are less than stellar. Its debatable whether the Sharpe ratio and its newer analog,
the M-square, are good measures of risk-adjusted return, but thats not the focus of this article. The fact is
that investors care about them, so if there are simple things you can do to increase them, it makes sense to
try. Im not talking about becoming a better manager so you can actually deliver higher risk-adjusted
returns to your clients Im talking about gaming the Sharpe ratio by making your ratio an upwardly
biased estimate of your true risk-adjusted return.
This is not a new idea. Investment managers employ a number of tactics to improve their measured
Sharpe ratio. For most asset classes, increasing the time interval used to measure standard deviation will
result in a lower estimate of volatility. For example, the annualized standard deviation of daily returns is
generally higher than weekly, which is again higher than monthly. Lengthening the measurement interval
will not alter return, but will generally lower the standard deviation a bit. Another trick involves the way
returns are reported. If the annual return measure is derived by compounding the monthly returns, but the
standard deviation estimate is calculated from the (not compounded) monthly returns, the Sharpe ratio
will be upwardly biased.1
Options change the return distribution. Rather than approximating a normal distribution, options
produce skewed, kurtotic, or leptokurtotic return distributions, depending on the choice of option types
and strikes. The standard approach to estimating volatility is unbiased even if the underlying distribution
is not normal, as long as the distribution has finite variance, so in theory options using options should not
bias the estimate of volatility. However, since the Sharpe ratio is generally calculated using relatively few
data points, strategies that sell the tails, such as writing out-of-the-money puts or calls, can often survive
1

several years without being hit. For example, writing a 10% out of the money put on a portfolio indexed
to the SP500 each month would probably generate 2-2.5% in annual premiums. Based on the empirical
distribution of monthly returns, this strategy has a 2/3 chance of surviving three years without paying off
once, and a 50% chance of surviving five years. If the manager is lucky, this strategy will show a
significantly higher Sharpe ratio, as the premiums flow directly to the bottom line with no apparent
increase in volatility. Strategies that involve taking on default risk, liquidity risk, or other forms of
catastrophe risk have the same ability to report an upwardly biased Sharpe ratio (witness the Sharpe ratios
of market-neutral hedge funds before and after the 1998 liquidity crisis).
Smoothing is also a source of potential bias. Some derivative structures, such as average price
options, can be used to smooth investment returns. Smoothing is also a potential problem when the
assets in a portfolio are difficult to mark to market. The investment manager (or the pricing model
employed by the manager or outside pricing service) may bias returns in ways that understate monthly
gains or losses, thereby reducing reported volatility.

A New Approach to Gaming the Sharpe Ratio

Unfortunately for managers, investors have caught on to most of these games. The approach
described in this article involves finding a way to get rid of your extreme returns. Obviously, big losses
hurt your absolute return as well as increase your standard deviation. Outsized gains arent helping as
much as you might think. They raise the average return, but they also increase the volatility. A great
month increases your Sharpe ratio up to a point, but a gain thats too big will actually lower your Sharpe
ratio.2 If you could hold cash instead of stocks during the best month and the worst months each year,
youd be able to report a higher Sharpe ratio most of the time -- even though your returns would probably
be a bit lower.
This works because of the way we calculate the Sharpe ratio. If returns are IID normally
distributed, the odds are a bit better than 50/50 that your best and worst months will be the two returns
2

farthest away from the mean (the other half of the time, your second best month is farther from the
average than your worst month, or vise versa). These distances are then squared, so together the largest
and smallest returns make the largest contribution to your measured volatility. Just about half the annual
variance (49.5%) comes from these two months.3 The other ten months together contribute the same
amount to your expected variance as the best and worst. That calculation assumes returns are normally
distributed. In reality, the distribution of monthly equity returns has fatter tails than the normal
distribution, so the extremes contribute a higher percentage to the measured volatility. Over the past 30
years, the best and worst months each year contributed an average of 56.5% of the annual variance, and
the remaining months an average of 43.5%.
Removing these two months from your reported returns does have a cost. If returns have a normal
distribution, then, on average, the distance between the best return and the average return will be the same
as the distance between the average return and the worst month (the distribution of the max and min is
symmetric about the mean). This means that the cost of getting rid of both the max and the min is, in
theory, twice the average monthly return. Since your portfolio will be held in cash during those months,
your portfolio will be earning the risk-free rate, so the expected cost of the strategy is twice the monthly
excess return (or 1/6th of the annual excess return). The excess return of stocks over Tbills has averaged
about 6% per year, so the expected cost would be about 1% per year.
The historical record suggests the cost would be a bit less than this. The average continuously
compounde (log) monthly return for the SP500 from 1970-1999 was 1.07% per year. However, the
average of the best/worst months was 0.66% and the average of all other months was 1.15%. The average
risk-free rate during the best and worst months was 0.56%, so the actual cost of implementing this
strategy over the past 30 years was 0.66%-0.56%, or about 10 basis points for each month eliminated (20
basis points per year).

1.1

Implementing the Truncated Return Strategy

It turns out that eliminating the best and worst returns each year isnt as hard as it might seem.
There is a relatively simple derivative structure that can be set up as a swap: You pay the best and worst
returns for your benchmark index each year, and the counterparty pays a fixed cash flow and hedges the
risk in the open market. Assuming your portfolio has a low tracking error to the benchmark, this will be
equivalent to eliminating your best and worst returns. If no counterparty is willing to take the risk, the
strategy can be implemented directly using options. Both options are detailed below.

1.2

Total Return Swap

There are many ways the swap could be set up, but this is probably the simplest. At the end of
each month, if the benchmark return is higher than the previous best month, you pay the counterparty a
sum equal the difference between the new best return on your benchmark index and the old best return.
Assuming you are long the underlying index, your return for the month is therefore equal to the old high.
At the end of the year, you will have recorded all the monthly gains except for the best one. Similarly,
each time there is a new worst month, counterparty pays you an amount equal to the difference between
the old worst and the current worst. Again, at the end of the year youll have all the bad months except
for the very worst.
The first two months each year will, by definition, either be a new best or a new worst, so in both
cases the counterparty will absorb those returns (If they are gains, you pay the return to the counterparty.
If losses, counterparty pays you) and will also pay you an amount equal to the monthly risk-free rate on
the investment. After the second month, cash flows only occur when a monthly return exceeds a new
high or low. Your realized returns will equal the risk-free rate for the first two months, followed by the
ten interior months. Total cash flows paid by investor over the course of the year (excluding fees paid to
the counterparty) will be

(r

max

r f ) + (rmin r f ) = (rmax + rmin ) 2r f

(1)

1.3

Implement the Strategy Yourself

Implementing the strategy is easy. The first two months of the year you hold only cash. As in the
swap example, your return for these months is the risk-free rate. Then, at the start of the third month, buy
the index and a 1-month put option struck at the lower of the first two monthly returns and write a call
option struck at the higher of the first two returns. If a new high is set, the call option will be exercised
and the total return will be equal to the old high. If a new low is set, you will exercise the put option and
your return will equal the old low. Each month the strategy is repeated, and at the end of the year, the
return series (excluding the cost of the options) is identical to the swap. The cost of the options will cause
the returns to deviate from the swap returns. In a risk-neutral world, the expected value of the high and
low return is symmetric around the risk-free rate, so the cost of the put should be about equal the amount
received from the call (depends on the type of option it will be exactly zero if the payoff is based on log
returns, slightly positive for standard puts and calls). However, there will be considerable variation in the
cost each month. Also, since equity puts usually have higher implied volatility than calls, puts will
usually cost more than is received from writing calls.4

1.4

Hedging the Extreme Value Swap

In a risk-neutral (Black-Scholes) world, the expected return of the underlying security is equal to
the risk-free rate. The expected payoff to the Extreme Value Swap (EVS) was shown earlier to be twice
the risk premium of the underlying security. Since the risk premium for all assets in a risk-neutral world
is zero, the risk-neutral expected payoff to the EVS is zero, so its initial value is zero. Once the swap has
begun, the value will change. While there is not a closed-form solution to the value of the EVS, it is
relatively straightforward to price the swap using numerical integration and to calculate the relevant
Greeks in the same way. Derivation of the pricing function and a method of numerically deriving the
derivatives are given in the appendix.

The payoff function (maximum return + minimum return) has a relatively low variance. The
standard deviation of the sum of the maximum and minimum returns is actually less than the standard
deviation of a single monthly return. In theory, the expected value of the sum is 82.5% of the monthly
standard deviation. In practice, the standard deviation of sum of the maximum and minimum SP500
monthly returns is almost exactly equal to the single month standard deviation (100.6% of the monthly
value). Because of the low volatility of the payoff, the delta and gamma of the EVS are well behaved, so
the risk to the counterparty and the cost of hedging the risk should be small.

Historical Performance of the EVS

Monthly returns of the SP500 index from 1970 to 1999 were analyzed. The annual Sharpe ratio
was calculated, along with the annual return and Sharpe ratio of the EVS over the same period. The
results are summarized in Exhibit 1.
-----------------------------------------Insert Exhibit 1 about here
-----------------------------------------Exhibit 1 shows that if an EVS had been implemented over this time period, annual return would
have been reduced by 0.2% per year from 12.9% to 12.7% and the annualized standard deviation (using
monthly data) would have been reduced by over a third from 15.4% to 10.2%. The Sharpe ratio for the
EVS sample is nearly twice as high as the SP500 (0.58 vs. 0.40), and the M2, which measures the return if
the asset had been levered to the same volatility has the benchmark, was 15.7% vs. 12.9% for the index.
-----------------------------------------Insert Exhibit 2 about here
------------------------------------------

These results are consistent with the theoretical results. In theory, the EVS provides and increased
risk-adjusted return as long as the annual risk premium is greater than zero and less than one annual
standard deviation. Exhibit 2 shows the relationship between expected risk premium and improved EVS

Sharpe ratio. As the expected risk premium increases, the volatility reduction of the EVS diminishes.
This is because two of the annual returns have a zero risk premium, so as the mean return moves farther
away from zero, these returns begin to add to the volatility.5 If the mean risk premium is larger than one
standard deviation, the EVS has a lower Sharpe ratio than the underlying asset. At the 6% annual risk
premium and 15% annual volatility experienced in the US stock market over the past 30 years, EVS
Sharpe ratio should have been 0.46 (about 15% above the 0.40 ratio for the market). As noted earlier, the
actual Sharpe ratio for the EVS was about 50% higher than the market, mostly due to the fact that EVS
volatility was a bit lower than predicted by the model (11.0% predicted, 10.2% actual). This is because
the largest and smallest returns contribute a larger percentage of total SP500 volatility than predicted, so
eliminating these returns reduced EVS volatility more than predicted. Also, the observed cost of the EVS
strategy was a lower-than-expected 0.2 percent per year versus a predicted cost of 1.0 percent per year.

Smoke and Mirrors

Can adding a derivative increase your Sharpe ratio? In theory, the answer is no. In a one-factor
world, the price of risk cannot be altered with derivatives. For an intuitive proof of this, see Hull (1999).
A derivative can alter your level of exposure to the underlying asset, but cant alter the risk-adjusted
return. This is true of options, futures, and also the EVS. However, unlike the other derivatives, the EVS
will increase the measured Sharpe ratio by inducing a bias into the calculation of the standard deviation.
This works by smoothing your return series. In effect, the EVS takes return away from the highest
monthly return and adds it to your lowest return. By shifting return around in this way, the estimate of
the standard deviation is reduced without affecting the total return in a meaningful way. This is different
than, say, an option collar. Writing a call option and buying a put option will truncate the returns in any
given month, but wont add the return back in a subsequent month.
The mathematical explanation for the volatility reduction is that eliminating the high and low
return destroys the statistical independence between monthly returns. When you use the standard method
7

of calculating the standard deviation, you are explicitly assuming independence. If monthly returns are
independent, the covariance between the assets is zero, so the formula (2),

( ri r )

(2)

n 1

gives and unbiased estimate of the variance. The returns of a censored distribution are not independent
observations of a random variable, so a different formula should be used to produce an unbiased estimate
the true variance of the underlying asset. While the EVS increases the Sharpe ratio when monthly data
are used to estimate the ratio, it has almost no effect on the Sharpe ratio when annual data are used. You
can see this by looking at the final row of the historical returns table. When annual returns are used to
calculate the Sharpe ratio, the ratio for the EVS (0.43) and the SP500 (0.41) are essentially same.

Conclusion: You Cant Eat These Risk-Adjusted Returns

In a Morgan Stanley research article Yes, You Can Eat Risk-Adjusted Returns (1997), Leah
Modigliani, one of the authors of the M2 risk-adjusted return measure, argued that risk-adjusted return is
a viable measure of portfolio performance because a low-Beta, high-Sharpe ratio portfolio can be levered
in order to provide a higher return for a given level of risk. This argument is one of the main selling
points for many hedge fund strategies that take short positions or write options in order to improve riskadjusted performance. However, you cant eat the improved Sharpe ratio of the EVS. It cant raise your
true Sharpe ratio, but it can make it appear higher. As risk-adjusted performance measures continue to
gain acceptance among investors, it has become more important than ever to understand the assumptions
and biases embedded in any measure of risk.

References
Coleman, T. and L. Siegel, Compensating Fund Managers for Risk-Adjusted Performance, Journal of
Alternative Investments, Winter, 1999
David, H., Order Statistics, Wiley, 1981
Hull, Options, Futures, & Other Derivaitves, Prentice Hall, 1999
Modiglaini, L., Yes, You Can Eat Risk-Adjusted Returns, Morgan Stanley Investment Perspectives,
1997

Appendix: Valuation and Analysis of the Extreme Value Swap:

Assumptions: Monthly returns are IID normally distributed with mean and variance 2. The risk-free
monthly rate of return is rf . Payoff to the EVS will take place at the end of the year and will be based on
continuously compounded returns:

rh = max ln t , t = 1, 2,...,12
St 1

rl = min ln t , t = 1, 2,...,12
St 1

EVS = ( Notional Amount ) ( rh + rl 2rf

(3)

If the desired payoff is in simple return, as opposed to continuously compounded return, the EVS payoff
could be modified so that

rh = max t 1, t = 1, 2,...,12
St 1

rl = min t 1, t = 1, 2,...,12
St 1

EVS = ( Notional Amount ) ( rh + rl 2rf

(4)

Making this change would involve using the lognormal distribution in the following analysis as
opposed to the normal, but the analysis would otherwise be identical. A more complicated extension of
the model would involve swapping the sum of the maximum and minimum monthly dollar changes. This
payoff pattern is the most precise way to swap the extremes. However, it also induces path dependence
into the equation, since the largest and smallest monthly dollar changes will depend on the location of the
underlying index at the start of each month. This question is not explored here. Clearly, there will be
some discrepancy between an EVS payoff based on a constant notional amount and the maximum and
minimum dollar change when the underlying asset is compounded through the year. This effect is likely
to be small, and the level of volatility reduction which is the source of the improved risk-adjusted
return, would be negligible. If desired, the tracking error could be eliminated by holding the underlying
1

asset in a monthly total return swap or by monthly rebalancing of the underlying index in order to achieve
a constant investment in the underlying at the start of each month.
Joint Distribution of Maximum and Minimum returns:
Let (x) and (x) represent the normal density and distribution functions for a single month, with
mean and variance 2. The joint probability density function of the highest (h) and lowest (l) of N
months is calculated by finding the probability that the low is exactly l, the high is exactly h, and the
remaining the months are between l and h. Since the high could occur in any of the N months and the low
in any of the remaining N-1 months, the joint density function is given by

f ( rl , rh ) = + N ( N 1) ( rl ) ( rh ) ( ( rh ) ( rl ) )

N 2

(5)

Once the year has begun, the problem becomes a bit more complex. Let (x|r*) and ( x|r*)
represent the normal p.d.f. and c.d.f. for a month that is already in progress, where r* is the return realized
since the start of the month. The mean and variance for the remainder of the month will be r*+ g and
g2, where g is the percentage of the month remaining. Let T be the number of months remaining in the
year, including the fraction remaining in the current month, N the number of whole months Int(T), and g =
N Int(N). The joint density of the highest (h) and lowest (l) of N monthly returns in the remaining T
months (from David, 1981) is given by,

f ( rl , rh ) = N ( ( rh ) ( rl ) )

N 1

* ( rl ) ( rh ) + ( rl ) * ( rh )

+ N ( N 1) ( rl ) ( rh ) ( ( rh ) ( rl ) )

N 2

( * ( rh ) * ( rl ) )

(6)

This formula follows the same intuition as (4), but is extended to include the partial month.
The EVS Value Function
Let rH and rL be the highest and lowest realized month-end returns year-to-date (so rH + rL 2rf is
the payoff if no new monthly highs or lows are realized). Then the expected payoff to the EVS will equal
the current payoff plus the expected increase in the monthly high and decrease in the low. The price of
the derivative with time t remaining to expiration is this payoff discounted at the risk-free rate.

EVS = e 12 rt ( max ( RH , h ) + min ( RL , l ) ) f ( l , h ) dhdl 2rf

l = h =l

(7)

(Note: If only one monthly return has been realized, this return is both rH and rL in the equation, if none
have been realized, then rH = , rL = )
Hedging an EVS
Derivatives of the EVS payoff function are not easily evaluated analytically, but are fairly simple
to evaluate numerically. For payoff function (3), the initial delta is zero. The EVS is a portfolio of
negatively correlated options. From the hedgers perspective, a large return in the current month reduces
the delta of the EVS (the hedger is short the EVS, which means a large return increases the short EVS
value, so the offsetting short hedge position in the underlying also increases). A large current return also
reduces the likelihood that subsequent months will set a new high, so the value of these later options (and
their contribution to the EVS delta) is reduced. The delta function is responds to changes in the expected
value of the largest month rather than the expected value of the current month. This function is less
sensitive to price changes than a standard option.
Simulation of the EVS Value and Delta of Dealer Hedge Position
This figure shows that as the month-to-date return (current return) varies, the delta behaves like an
option collar delta hedge (more negative at high current return and also at low current return, roughly zero
at a zero current return). Given the parameters used to generate the figure (prior maximum of 8%, prior
minimum of 2%) the inflection point is higher than zero because the expected payoff is positive. The
payoff at the start of the current month (assuming no further monthly high or low) was 8%+ (-2%) less
twice the monthly risk-free rate (0.5%), for a total of 5.0%. The EVS value is less than 5% because the
probability that the low would be exceeded in subsequent months is much higher than the probability that
the current maximum would be exceeded.
-----------------------------------------Insert Exhibit A1 about here
-----------------------------------------Simulation of the Gamma of Dealer Hedge Position
3

Shows that the as the month-to-date return (current return) varies, gamma is also relatively
smooth. Inflection points for gamma near 6.5 and +8.5 reflect the fact that if return current return is
below 6 or above +8, chances are that the current month will be the maximum or minimum. For current
returns below 6.5, the difference between the current return and the expected minimum return begins to
contract. So while the delta is still declining, it is declining at a slower rate.
-----------------------------------------Insert Exhibit A2 about here
-----------------------------------------Simulation of Change in EVS Value over Time
This simulation holds the current return at zero, and tracks the value of the EVS over a threemonth period. Since expected payoff is 5% (8%-2%-1%), EVS value steadily converges to expected
payoff as time passes and no new highs or lows are set. The rate of convergence is not constant because
the current maximum (8%) and minimum (-2%) parameters make it much more likely that a new low will
be set than a new high. As each month ends, it becomes less likely that the current month will set a new
low, so the rate of convergence increases. As a new month starts, there is a high chance of a new low, so
the EVS value remains relatively stable. The rate of convergence also increases from month to month, as
there are fewer opportunities to set a new low.
-----------------------------------------Insert Exhibit A3 about here
-----------------------------------------Extensions of the EVS Model
While it is not clear why one would want to, it is relatively easy to write derivatives on the EVS
payoff. For example, if an investor believed the maximum annual return would be much larger than the
minimum, a call option on the (max + min) could be priced by integrating the payoff over the joint pdf

EVSPayoff ( h + l 2rf

EVSCall = e 12 rt max ( EVSPayoff X , 0 ) f ( l , h ) dhdl

l = h =l

(8)

Exhibit 1: Hypothetical Performance of EVS Swap, 1970-1999

Total
Return
3.9
13.4
17.4
-16.1
-30.9
31.8
21.3
-7.7
6.3
17.1
28.2
-5.1
19.6
20.4
6.0
27.6
17.1
5.1
15.3
27.6
-3.2
26.6
7.4
9.6
1.3
31.9
20.7
28.8
25.1
19.1

StDev
Annual
20.3
13.6
6.1
14.8
23.7
17.5
13.5
9.4
16.7
13.5
18.2
12.9
18.5
9.9
13.7
11.8
17.9
32.5
10.2
12.2
18.3
15.4
7.4
5.9
10.7
5.1
10.7
15.8
22.2
13.0

EVS
Sharpe Total Ret
-0.2
6.9
0.7
9.6
2.3
15.2
-1.5
-7.5
-1.6
-32.9
1.5
27.4
1.2
12.5
-1.3
-6.8
0.0
7.9
0.6
19.5
0.9
30.5
-1.6
-1.9
0.4
16.0
1.2
17.1
-0.2
2.7
1.7
24.6
0.6
19.8
0.0
17.7
0.9
15.4
1.6
22.9
-0.6
-1.4
1.3
21.4
0.5
6.1
1.1
8.8
-0.2
2.3
5.2
29.0
1.5
18.7
1.5
27.8
0.9
33.8
1.1
16.8

EVS
StDev
16.1
9.8
4.0
8.2
11.0
11.1
7.8
6.3
10.2
9.5
9.7
10.1
13.3
6.1
5.9
9.0
13.1
14.6
8.2
9.0
12.0
10.4
5.8
4.0
8.7
4.8
6.5
12.5
10.7
11.1

EVS
Sharpe
0.0
0.6
3.0
-1.6
-3.7
1.9
1.0
-1.8
0.1
1.1
1.8
-1.7
0.2
1.5
-1.1
1.8
1.0
0.8
1.2
1.6
-0.8
1.5
0.4
1.5
-0.1
4.9
2.1
1.8
2.7
1.1

EVS MaximumMinimum Monthly

2
M
Month Month
TBill
6.8
7.4
-9.2
0.63
11.7
8.5
-4.0
0.34
21.7
4.7
-2.0
0.28
-18.2
4.2
-11.8
0.46
-79.8
15.6
-12.3
0.63
39.8
12.0
-6.7
0.49
18.1
11.5
-1.9
0.41
-12.7
4.8
-4.9
0.39
8.9
8.7
-9.2
0.54
23.7
5.8
-6.7
0.79
46.1
10.2
-10.3
1.05
-6.6
5.3
-6.0
1.27
17.2
11.5
-5.7
1.09
22.8
7.6
-3.0
0.67
-5.6
10.5
-5.7
0.76
29.8
7.5
-3.2
0.67
24.3
7.2
-8.7
0.59
32.6
12.7
-24.3
0.46
17.7
4.6
-3.6
0.48
28.0
8.8
-2.6
0.71
-6.1
9.1
-9.6
0.65
28.7
10.8
-4.6
0.51
6.7
4.1
-2.2
0.32
11.6
3.6
-2.3
0.25
2.1
3.9
-4.5
0.26
30.3
4.2
-0.3
0.48
27.6
7.3
-4.5
0.41
33.9
7.7
-5.8
0.42
64.7
7.9
-15.6
0.42
18.9
6.2
-3.2
0.37

EVS
Payoff
3.0
-3.9
-2.2
8.6
-2.0
-4.4
-8.8
0.8
1.6
2.4
2.2
3.2
-3.6
-3.3
-3.3
-3.0
2.6
12.6
0.0
-4.7
1.8
-5.2
-1.3
-0.8
1.0
-3.0
-1.9
-1.0
8.6
-2.3

Avg
Annual
Return
70-79 Monthly
5.7
80-89 Monthly
16.2
90-99 Monthly
16.7

StDev
Annual
15.9
16.6
13.4

Avg
EVS
Sharpe Total Ret
-0.02
5.2
0.41
16.5
0.88
16.3

EVS
StDev
10.6
10.2
9.4

EVS
Sharpe
-0.07
0.70
1.22

Avg
Avg
Avg
EVS MaximumMinimum Monthly
2
M
Month Month
TBill
4.8
8.3
-6.9
0.50
21.0
8.6
-7.3
0.78
21.2
6.5
-5.3
0.41

Avg
EVS
Payoff
-0.48
0.29
-0.40

1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999

90-99 Monthly
90-99 Year-End

12.9
12.9

15.4
14.9

0.40
0.41

12.7
12.7

10.2
13.9

0.58
0.43

15.7
13.1

7.8

-6.5

0.56
0.6

-0.20

Exhibit 2: Increase in Expected Sharpe Ratio for Various Market Risk Premiums*
Expected
Annual
Risk Premium
-12%
-9%
-6%
-3%
0%
3%
6%
9%
12%
15%
18%
21%
24%
27%
30%

Expected
StDev
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%

Sharpe
Expected
Ratio
EVS Payoff
(0.80)
2.0%
(0.60)
1.5%
(0.40)
1.0%
(0.20)
0.5%
0.0%
0.20
-0.5%
0.40
-1.0%
0.60
-1.5%
0.80
-2.0%
1.00
-2.5%
1.20
-3.0%
1.40
-3.5%
1.60
-4.0%
1.80
-4.5%
2.00
-5.0%

Expected
Expected
Difference
EVS Stdev EVS Sharpe in EVS Sharpe
11.9%
(0.84)
(0.04)
11.3%
(0.66)
(0.06)
11.0%
(0.46)
(0.06)
10.7%
(0.23)
(0.03)
10.6%
10.7%
0.23
0.03
11.0%
0.46
0.06
11.3%
0.66
0.06
11.9%
0.84
0.04
12.5%
1.00
0.00
13.2%
1.13
(0.07)
14.0%
1.25
(0.15)
14.9%
1.34
(0.26)
15.9%
1.42
(0.38)
16.9%
1.48
(0.52)

Exhibit A1

Value and Delta of EVS Hedge Position Based on Current Month's Return
(Value Left Axis, Delta Right Axis)
4

0.8
Parameters:
Current Maximum: 8%
Current Minimum: -2%
Standard Deviation (annual): 20%
Risk-Free Rate (annual): 6%
Full Months Remaining: 6
Current Month Remaining: 0.5

EVS Expected Payoff (%)

0.6

0.4
EVS Value
0.2

-1

-0.2
EVS Delta

-2

-0.4

-3

-0.6

-4

-0.8
-10

-9

-8

-7

-6

-5

-4

-3

-2
-1
0
1
2
Current Return (% )

10

EVS Delta (% of Notional)

Exhibit A2

Delta and Gamma of EVS Hedge Position Based on Current Month's Return
(Delta Left Axis, Gamma Right Axis)

5%

-0.1

4%
EVS Delta

3%

-0.3

2%

-0.4

1%

-0.5
Parameters:
Current Maximum: 8%
Current Minimum: -2%
Standard Deviation (annual): 20%
Risk-Free Rate (annual): 6%
Full Months Remaining: 6
Current Month Remaining: 0.5

-0.6
-0.7
-0.8
-0.9

0%

EVS Gamma

-1%
-2%
-3%
-4%

-1

-5%
-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

Current Return (%)

10

EVS Gamma (%)

EVS Delta (%)

-0.2

Exhibit A3

Change in EVS Value over 3-Month Period

2.2
Parameters:
Current Maximum: 8%
Current Minimum: -2%
Standard Deviation (annual): 20%
Risk-Free Rate (annual): 6%
Current Return: 0%

EVS Expected Payoff (%)

1.8

1.6

1.4

1.2

1
7.0

6.8

6.6

6.4

6.2

6.0

5.8

5.6

5.4

5.2

Months Remaining

5.0

4.8

4.6

4.4

4.2

This trick would have increased the estimated annual risk premium of the SP500 by about 2% over the past

thirty years (from 6% to 8%), which would increase the estimated Sharpe ratio by about a third. The reason for this
is that towards the end of the year, the asset value will be (on average) higher than at the start. If compound returns
are used, the dollar impact on the portfolio in the later months of the year is greater than in the early months. For
the SP500, which as gained about a percent per month (1970-1999), this means that dollar volatility in December is
about more than 10% higher than in January. However, the since returns (not dollars) are used to estimate standard
deviation, this effect does not carry over to the measure of volatility. This method of calculating the Sharpe ratio is
not AIMR-compliant, but still crops up quite often.
A large gain will increase the Sharpe ratio as long as the return is less than x + ( SD Sharpe ) ( n 1) n ,
where x , SD, and Sharpe, and n are the sample mean, standard deviation, Sharpe ratio, and number of observations
2

excluding the outlier gain. For example, using monthly data from the SP500 in the 1990s (average monthly return
of 1.4%, monthly StDev of 3.8%, annual Tbill rate of 4.9%), this formula indicates that a monthly gain above 14.5%
would begin to reduce the Sharpe ratio for the year. If maximizing Sharpe ratio is the sole objective, investors
would always sell calls at this strike to prevent reduction in risk-adjusted return and collect some premium.
3

Assumes IID Normal Distribution. If you measure the standard deviation using weekly, rather than

monthly, the effect is less pronounced. The best and worst weeks each year contribute should, in theory, contribute
21% of the squared annual deviations. The opportunity to game the Sharpe ratio is less if your firm calculates it
using weekly numbers.
4

One might be able to convince a broker to quote the entire series of options up front. This would resemble

a lookback option the owner of the call would be able to look back and exercise a 1-month call option at the most
advantageous price (the highest monthly return).
5

While it may seem odd to think that adding risk-free returns can increase volatility, this is because variance

is calculated by squaring deviations from the observed mean. If the true mean is high, replacing two observed
returns with risk-free returns will involve adding two returns that are far below the observed mean. Squaring the
difference between these returns and the observed mean can add more variance than the maximum and minimum.