Re-Evaluating Sharpe Ratio in Hedge Fund Performance in Light of Liquidity Risk
Re-Evaluating Sharpe Ratio in Hedge Fund Performance in Light of Liquidity Risk

Summary/Abstract: This paper demonstrates how the Sharpe Ratio can be modified by altering the measure of “totalrisk” in the denominator of the Sharpe Ratio (i.e., the standard deviation) to include liquidityrisk, a major risk for investors in hedge funds that is missing from the standard Sharpe Ratioformulation. We refer to our liquidity-risk-adjusted performance ratio as the LRAPR. The resultsof our analysis of 1186 hedge funds alive in 2012–2020 show that funds with higher liquidity riskexhibit higher Sharpe Ratios and higher Alphas (as estimated in a 7-factor model that does notincorporate liquidity risk). We posit that analysts and investors should not necessarily take thesehigher Sharpe Ratios and higher Alphas as indications of fund superiority; what appears to besuperior manager skill may rather be a compensation for bearing liquidity risk. Our LRAPR isa tool that analysts or investors could use to compare funds on a more equal footing, adjusting fordifferential liquidity risk across funds.

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