14 – M4 L3a 13 Sharpe Ratio V4

The sharpe ratio, sometimes referred to as the risk adjusted return, is a key metric for evaluating alpha factors. This is the ratio of the daily factor return divided by the daily standard deviation of the return. As an example, if we had three years worth of daily data, we could calculate the average daily return over those three years and divide by the sample standard deviation of those daily returns, and then analyse that by multiplying by the square root of the number of trading days in a year. If we have two factors that have the same universe and similar turnover profiles, we will prefer the one with the higher sharpe ratio. Sharpe ratio is the key metric that institutional asset managers are judged on. Note that the Sharpe ratio, like many evaluation metrics for alpha factors, help us to compare the relative performance of alpha vectors. The sharpe ratio is key, not the magnitude of factor returns. Because as we learned in the immediately preceding section, we can amplify or dampen returns by the use of leverage. It is the sharpe ratio that gives us the confidence to apply that leverage.

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