Spotlight On Sharpe Ratio

by: Clark Capital Management Group

K. Sean Clark, CFA, Chief Investment Officer

Risk/Return Profiles in Declining and Rising Rate Environments

Fixed income has traditionally had two primary roles in portfolio construction: income generation and volatility management. With yields hovering at historic lows, bond portfolios could decline if interest rates rise. Income is often a critical component of investors’ financial needs and a rise in rates could dramatically affect the fixed income allocation in a portfolio. On a risk-adjusted basis, traditional fixed income may have dramatically different return characteristics over the next market cycle mitigating its use as a volatility management tool.

Take for instance, the Sharpe ratio of a 60/40 portfolio during a rising interest rate environment and during a declining interest rate environment:

  • A 60/40 portfolio from 1954-1982 (rising interest rate) – Sharpe ratio of .28
  • A 60/40 portfolio from 1983-2013 (declining interest rate) – Sharpe ratio of .68

LT-Government-Yield-(forSharpeRatio)

For illustrative purposes only. The information is not intended to be a recommendation to purchase or sell a security. Past performance is no guarantee of future results. Returns reflect reinvestment of capital gains and dividends, if any. Indices are unmanaged and do not incur fees. It is not possible to invest in an index. Stocks are represented by the S&P 500 Index. Bonds are represented by the Ibbotson Associates U.S. Long Term Government Index. Inflation-adjusted returns are based on the average Consumer Price Index (CPI) through the referenced period. Most recent data available.

The Sharpe ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. Standard deviation is a measure of a portfolio’s volatility.

In short, the higher the Sharpe ratio, the better the returns on a risk-adjusted basis. A portfolio may have high returns, but if it takes on a lot of risk, it may have a similar Sharpe ratio to a portfolio with lower returns and less volatility or inherent risk. In addition, a portfolio that takes a lot of risk to gain incremental returns is likely to have the additional risk negatively affect its return.

Historically, in a declining interest rate environment, there is a more favorable risk/return profile (higher Sharpe ratio) than in a rising rate environment.

If and when we move into a period of rising interest rates, traditional fixed income may not offer both risk management and capital appreciation. At certain periods, it might offer neither. By incorporating nontraditional fixed income strategies into a portfolio, clients can build a portfolio with appropriate risk characteristics.

Clark Capital believes investors will benefit from a nontraditional, flexible approach that targets opportunities and manages risk in fixed income. Historically, in a rising rate environment, high yield/lower quality debt outperforms high quality debt. Clark Capital emphasizes a tactical approach to managing credit exposure, and believes that investors are rewarded for moving into lower credit fixed income sectors during a rising interest rate environment as long as risk is being managed.

Disclosure: The opinions expressed are those of the Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investment portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The relative strength measure is based on historical information and should not be considered a guaranteed prediction of market activity. It is one of many indicators that may be used to analyze market data for investing purposes. The relative strength measure has certain limitations such as the calculation results being impacted by an extreme change in a security price. Not every client’s account will have these exact characteristics. The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment.

Clark Capital Management Group, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. The information provided in this report should not be considered a recommendation to purchase or sell any particular security, sector or industry. There is no assurance that any securities, sectors or industries discussed herein will be included in or excluded from an account’s portfolio. It should not be assumed that any of the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Clark Capital Management Group, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Clark Capital’s advisory services can be found in its Form ADV which is available upon request.