Working Paper: CEPR ID: DP1885
Authors: Lars Tyge Nielsen; Maria Vassalou
Abstract: This paper proposes instantaneous versions of the Sharpe ratio and Jensen?s alpha as performance measures for managed portfolios. Both are derived from optimal portfolio selection theory in a dynamic model. The instantaneous Sharpe ratio equals the discrete Sharpe ratio plus half of the volatility of the fund. Hence, it does not penalize fund managers for taking risks as much as the discrete ratio does. This is justified by dynamic portfolio theory. Unlike their discrete versions, the instantaneous performance measures take leverage correctly into account in a dynamic setting, and they take into account investors rebalancing their portfolios over time.
Keywords: Sharpe ratio; Jensen's alpha; Performance evaluation; Fund management
JEL Codes: G11; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| instantaneous Sharpe ratio (G19) | expected utility (D81) |
| instantaneous Sharpe ratio (G19) | investor's decision-making process (G11) |
| discrete Sharpe ratio + half of the volatility of the fund (C46) | instantaneous Sharpe ratio (G19) |
| higher instantaneous Sharpe ratio (G19) | higher expected utility (D11) |
| positive Jensen's alpha (G12) | increase in expected utility (D11) |
| instantaneous alpha (C69) | discrete alpha (C69) |