How to Game Your Sharpe Ratio

Abstract

The Sharpe ratio is a commonly used measure of return/risk performance. However, the Sharpe ratio is susceptible to gaming by managers. 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.