Interpreting Sharpe Ratios - The Market Climate Bias

This article adds new insights to the ongoing discussion of whether the Sharpe ratio is appropriate to assess the performance of funds in abnormal periosd, e.b., when average excess returns of funds are negative. We show two main factors influencing the Sharpe ratio: first, of course, the quality of the fund management and second, the innovative aspect, the significance of the market climate during the evaluation period. Because of the influence of the market climate, a fund with constant fund-specific characteristics that outperforms the Sharpe ratio of the market index in a declining market will not necessarily have a superior Sharpe ratio in a normal market period. Moreover, based on US equity mutual fund data we discover that market clmates have a considerable impact on fund rankings. In order to overcome this market climate bias we suggest using the "normalized" Sharpe ratio in performance measurement.