Why Sharpe Ratio is Not a good measure of Trading Performance. Use CAGR to Maximum Drawdown Ratio instead!

The Sharpe ratio is widely used to evaluate the risk-adjusted return of trading strategies, defined as the ratio of excess return over the risk-free rate to the standard deviation of returns. While it provides a quick metric to compare strategies, it has several limitations, particularly for strategies in financial markets, where returns often exhibit fat tails and other non-normal characteristics. Here’s why the Sharpe ratio can be misleading:

1. Fat Tail Problem

Financial returns often follow a distribution with fat tails (excess kurtosis) and skewness rather than a normal distribution. In these cases:

 • The standard deviation (used in the denominator of the Sharpe ratio) fails to adequately capture the actual risk of extreme losses or gains.

 • Strategies that appear stable under normal market conditions can have large, rare drawdowns that the Sharpe ratio overlooks.

Example: A high-frequency trading strategy might have a high Sharpe ratio due to consistent small profits, but it may suffer catastrophic losses during market crashes, which are not reflected well in its standard deviation-based risk assessment.

2. Averaging of Standard Deviation

The Sharpe ratio assumes that volatility is evenly distributed over time, but:

 • Markets often exhibit heteroscedasticity (periods of high and low volatility).

 • Averaging the standard deviation across time periods smooths out the spikes in volatility, underestimating risk in volatile periods and overestimating it in calm periods.

This smoothing effect can create a false sense of stability, as the Sharpe ratio fails to differentiate between strategies that have steady risk profiles and those with fluctuating risks.

3. Does Not Account for Path Dependency

The Sharpe ratio ignores path dependency, which is critical for assessing a trading strategy’s robustness.

 • A strategy with small losses followed by a large gain might have the same Sharpe ratio as one with consistent small gains but catastrophic drawdowns. However, the capital preservation risk in the latter is much higher.

4. Misleading for Non-Normal Return Distributions

 • Many trading strategies have asymmetric returns, such as trend-following strategies with small losses and occasional large gains, or mean-reverting strategies with frequent small gains and rare large losses. The Sharpe ratio cannot adequately evaluate such non-linear payoff profiles.

Solution: CAGR to Max Drawdown Ratio

To address these shortcomings, CAGR (Compound Annual Growth Rate) to Maximum Drawdown (Max DD) ratio is often a better metric. Here’s why:

 1. CAGR Reflects Long-Term Growth:

CAGR measures the geometric mean annualized return, reflecting the compounded growth rate of a portfolio over time. It is not sensitive to short-term fluctuations, unlike arithmetic averages.

 2. Max Drawdown Captures Worst-Case Risk:

Max drawdown represents the maximum observed loss from a peak to a trough during a specific period, focusing on the most severe downside risk rather than average volatility.

 3. Combining CAGR and Max Drawdown:

The ratio directly compares return growth to downside risk:

 • A higher ratio indicates that the strategy delivers significant growth relative to its worst historical loss, making it more robust.

 • This metric avoids the pitfalls of normality assumptions and emphasizes capital preservation, which is critical in trading.

Example: If Strategy A has a CAGR of 15% and a Max Drawdown of 10%, its CAGR/Max DD ratio is 1.5. A competing Strategy B might have a Sharpe ratio of 2 but suffers a 30% Max Drawdown, making it less appealing to investors concerned with large losses. Furthermore you can apply leverage on Strategy A and still get less drawdown as compared to Strategy B.