Under realistic borrowing limits, the Sharpe ratio fails to align with investor utility. The geometric mean — and its shrinkage-based generalized version — offer superior estimates of future performance and improve mutual fund selection outcomes.
Interested in having your article published in the Financial Analysts Journal? Find out how.
Abstract
The Sharpe ratio is almost perfectly aligned with investors’ welfare when borrowing is unrestricted. However, when borrowing is realistically restricted, this alignment breaks down dramatically. We show that the geometric mean (GM) provides a much better alternative for fund ranking in this case. Estimates of the ex-ante GM can be improved by first shrinking the sample gross GM and then subtracting fees. The generalized GM (GGM) captures this idea and provides a good estimate of the future net GM. We argue that mutual fund selection can be substantially improved by employing the GGM rather than the more popular Sharpe ratio or alpha.