Keywords
liquidity risk; liquidity risk factor; serial correlation; Sharpe ratio; hedge fund performance
Abstract
This paper demonstrates how the Sharpe Ratio can be modified by altering the measure of “total risk” in the denominator of the Sharpe Ratio (i.e., the standard deviation) to include liquidity risk, a major risk for investors in hedge funds that is missing from the standard Sharpe Ratio formulation. We refer to our liquidity-risk-adjusted performance ratio as the LRAPR. The results of our analysis of 1186 hedge funds alive in 2012–2020 show that funds with higher liquidity risk exhibit higher Sharpe Ratios and higher Alphas (as estimated in a 7-factor model that does not incorporate liquidity risk). We posit that analysts and investors should not necessarily take these higher Sharpe Ratios and higher Alphas as indications of fund superiority; what appears to be superior manager skill may rather be a compensation for bearing liquidity risk. Our LRAPR is a tool that analysts or investors could use to compare funds on a more equal footing, adjusting for differential liquidity risk across funds.
Recommended Citation
Van Horne, R., & Perez, K. (2024). Re-Evaluating Sharpe Ratio in Hedge Fund Performance in Light of Liquidity Risk. Journal of Banking and Financial Economics, 2021(16), 91-103. https://doi.org/10.7172/2353-6845.jbfe.2021.2.5
First Page
91
Last Page
103
Page Count
103
Received Date
8 November 2021
Revised Date
17 December 2021
Accept Date
18 December 2021
Online Available Date
30 December 2021
DOI
10.7172/2353-6845.jbfe.2021.2.5
JEL Code
G12; G23; C18
Publisher
University of Warsaw