Sharpe ratio limitations for hedge funds?

CFA Level III
#1

The text explains several limitations regarding the use of the sharpe ratio when evaluating funds. The first is time dependency. It says, for example, the sharpe ratio for a fund using quarterly returns, the analyst multiplies the quarterly return by 4…

My question: why not compound the quarterly return to find the annual return instead of multiplying? Is this specific when using sharpe ratio? Bc the rest of the text on hedge fund return says how they normally calculate simple holding period monthly returns and annualize by compounding so wondering why they multiply when finding annual returns as part of calculating sharpe ratio.

I guess this cuts back to Level I days, but when should you multiply to get annual return vs compounding? I thought you always compounded when annualizing…unless you have a bond but that’s different bc it’s a BEY.

Any help clarifying would be greatly appreciated! Thank you

#2

problem is not in the multiplication of the returns by four or the compounding.

it is the process used for the standard deviation on the denominator.

Say you have monthly results -> and a standard deviation of s.

s*sqrt(12) = standard deviation for a year.

r * 12 = annual return. (for the purposes of simplification I used the simple factor of multiplying by 12). But even if you compounded - you would find the same result.

so now sharpe ratio went up by a factor of sqrt(12) whereas it might not have been really so.

#3

Generally the arithmetic Mean return is higher than the geometric compounded return and the difference increases as the portfolio volatility rises .it does look unfair to use arithmetic returns when the investor should realistically expect only geometrically compounded return from a risky portfolio ,

As CPK points out it is a simplification that CFA uses