Blog

The Sharpe ratio is a widely used measure of risk-adjusted performance. Instead of asking only how much an investment returned, it asks how much it returned relative to the variability an investor endured to get that return. This article is educational only; it is not investment advice, and nothing here is a recommendation of any fund, account, or strategy.

The calculation has three inputs. Take the investment’s rate of return over a period, subtract a benchmark rate, conventionally the return on a short-term instrument often described as the risk-free rate, and divide the difference by the standard deviation of the investment’s returns over the same period. The result expresses excess return per unit of return variability. The phrase risk-free is a modeling convention for that benchmark input, not a description of any investment available to anyone: every investment involves risk, and no return is assured.

Read carefully, the ratio compares smoothness, not just size. As a hypothetical illustration, if two programs report the same return over the same period, the one whose returns varied less along the way shows the higher Sharpe ratio. That is the ratio doing its job: rewarding the same result achieved with less measured volatility.

A higher ratio is only meaningful under consistent inputs. Comparisons require the same measurement period, the same return frequency, the same benchmark rate, and the same annualization method; change any of these and the numbers are no longer comparable. The benchmark rate itself moves with market conditions, which is why this article uses no specific figure for it.

The distinction between measurement and prediction matters most. Computed from realized returns, the Sharpe ratio is a historical description of one period. Computed from projected returns, it is only as good as the projections, which are estimates, not facts. In neither form does the ratio predict future returns, and a strong historical ratio is not an assurance of future results.

The ratio also has limits as a risk measure. Standard deviation treats upside and downside variability alike, and returns that arrive in rare large moves can make a track record look smoother than the underlying risk was. A short measurement window can flatter a strategy that has not yet seen difficult conditions. For these reasons, the Sharpe ratio is one input into due diligence alongside the manager’s disclosures and track record, not a verdict by itself.

How any measure applies to a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

Related articles on this site cover the Forex market, correlation, managed accounts and hedge funds, the time frame of a Forex funds investment, and how to evaluate a manager’s track record.

Not too long ago, a trader asked me to review his track record, but I only had 5-minutes to do the review.  Is it possible to examine a track record in five minutes?   The answer is: yes. It should just take a few minutes to analyze a well-documented Forex track record*.

Unfortunately, most track records are poorly organized and difficult to glean any information from regardless of how long the reviewer has to peruse the trade statistics.  Well-organized track records will tell the reviewer the following (not listed in the order of importance):

1. The Forex trader’s name,  location and the name of the program.
2. Regulatory jurisdiction.
3. Brokers name and location.
4. Amount of assets that are under management.
5. Peak to trough draw-down.
6. Length of the trading program.
7. Month by month returns and  AUM.

Notional funding is an arrangement sometimes used in managed Forex accounts in which the account is traded as if it were larger than the cash actually deposited. Understanding it requires separating two numbers that are easy to confuse. This article is educational only; it is not investment advice, and nothing here is a recommendation of any funding arrangement.

The first number is the actual funds: the cash the investor has deposited in the account. The second is the nominal, or notional, account size: the level at which the investor and manager have agreed the account will be traded, as set out in their agreements. When the nominal size exceeds the actual funds, the difference is the notional portion, and the essential point is that the notional portion is not cash. It is an agreed trading level, not money sitting in the account.

That difference changes how gains and losses feel. Position sizes in a notionally funded account are typically based on the nominal size, while gains and losses land on the smaller base of actual cash. Trading a nominal size larger than the deposited cash therefore raises the effective leverage on that cash, and leverage amplifies both gains and losses. A percentage move that would be modest relative to the nominal size can be a much larger percentage of the actual funds.

Funding needs are also not fixed. Brokers require margin, deposited value held to support open positions, and what an account must post can change. If a broker changes its margin requirements, whether for its own reasons or in response to capital or regulatory changes, an account holding the same positions may need more cash to support them. Trading losses reduce actual funds, which can also prompt a request for additional cash if the account is to keep trading at the agreed level, and depending on the account’s terms, losses can exceed the amount deposited.

None of this is knowable from the label alone. How a notional arrangement works in a specific account, including the agreed trading level, the margin terms, and what happens when actual funds decline, is defined by the exact account and management agreements and by the written risk disclosures that accompany them. Reading those documents before funding, and asking about anything unclear, is the ordinary starting point.

Whether any funding arrangement fits a particular portfolio is a judgment each investor must make independently, ideally with a qualified professional. Trading foreign exchange involves substantial risk of loss and is not suitable for every investor.

Related articles on this site cover the Forex market, managed accounts and hedge funds, correlation, and how to evaluate a manager’s track record.

Investing in emerging Forex traders (these traders are sometimes called managers) can be extremely rewarding, or it can be extremely disappointing.  Similar to athletics, catching a rising star before anybody else notices a person’s talents can be financially rewarding for both the discoverer and the discovered.  Generally, as assets under management grow, returns shrink. And here’s the paradox: the longer you wait for a emerging Forex trader’s track record to become statistically significant, the more likely it is that that manager is going to acquire more assets under management and the managers track record will suffer due to the law of diminishing returns. Forex fund investors know it is easier to manage a $100 thousand than  $50 million.

An investment is said to be in a drawdown when the account equity falls below the accounts last equity high. The drawdown percentage drop in the price of an investment from its last peak price. The period between the peak level and the trough is called the length of the drawdown period between the trough, and the recapturing of the peak is called the recovery. The worst or maximum drawdown represents the highest peak to trough decline over the life of an investment. The drawdown report presents data on the percentage drawdowns during the trading program’s performance history ranked in order of magnitude of loss.

• Start Date: Month in which peak occurs.
• Depth: Percentage loss from peak to valley
• Length: Duration of drawdown in months from peak to valley
• Recovery: Number of months from valley to new high

Investing in Forex is speculative and tends to be cyclical. Additionally, even the most successful professional traders experience periods of flat returns or even drawdowns. Consequently, those trading periods will suffer losses. The wise investor will remain steadfast in his/her investment plan and not close the account prematurely to allow the account to recover from temporary losses in equity. It would not be a wise investment strategy to open an account that you do not intend to maintain for at least six to none months.