Sharpe ratio measures risk adjusted returns
Despite its well-documented weak points, the Sharpe ratio is still one of the most commonly used measures by investors to gauge the quality of funds of hedge funds from a risk-adjusted point of view. In essence the Sharpe ratio measures the return achieved per unit of risk. Ratio is calculated by dividing the excess return of the analysed fund – over a predefined hurdle-rate – by the volatility of the funds return. The discussion whether the Sharpe ratio is a suitable measure for evaluating the risk-adjusted performance of hedge funds is still ongoing, both in academia and in practice. The most common objection against the usage in the case of hedge funds is their underlying asymmetric risk-return profile. Due to the fact that volatility is a symmetric risk measure, it’s widely accepted that the Sharpe ratio is not able to incorporate the non-normality of the return distributions caused by the asymmetric risk-return profiles of hedge funds. However, given the inherent diversification of funds of hedge funds their return distributions are not so extremely away from the normal distribution as single hedge funds. Nevertheless, they still do exhibit high autocorrelations, which cause the classical Sharpe ratio to be biased. That finding is documented by Lo (The Statistics of Sharpe Ratios in Financial Analysts Journal, Vol. 58 No. 4, pp. 36-52.), which provides a robust calculation of the Sharpe ratio, which takes into account serial correlation in monthly returns. Notwithstanding the mentioned shortcomings, many investors still use the Sharpe ratio as a core input into their decision-making process, mainly due to its easy calculation and being readily availability. Some fund managers even promote their funds based on an exceptional Sharpe ratio. If we accept the shortcomings and to base your decision on it, as many investors do, the important question then becomes: how reliable are Sharpe ratios, especially, how persistent is the performance of funds of hedge funds with a historical high Sharpe ratio? We tested whether in fact Sharpe ratios persisted on a multi-year time frame, especially in relation to multi-strategy fund of hedge funds. In order to ensure that the Sharpe ratio of a fund is not a function of the environment during specific period of evaluation, or of the number of months the fund has been running, we used a rolling time period window to evaluate the Sharpe ratio for all funds. The rolling approach also enables us to incorporate funds that stop reporting during the sample period. These funds are normally classified as dead funds. Due to the fact that the study also considers dying funds, our results should not be heavily exposed to the classical survivorship bias. Furthermore, we are not limited to funds, which report throughout the whole period. Therefore, the number of analysed funds can increase or decrease whether more funds begin reporting to Eurekahedge or stop reporting and vice versa. The analysed universe starts with 71 funds in January 1995 while that number increases to 584 in August 2008 before dropping down to 455 in December 2009. For the sake of the analyses we focus on US-Dollar denominated multi-strategy funds of hedge funds.

Are Sharpe ratios stable over time?
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