Practical Applications of The Shrinkage-Adjusted Sharpe Ratio: An Improved Method for Mutual Fund Selection

Abstract

In The Shrinkage-Adjusted Sharpe Ratio: An Improved Method for Mutual Fund Selection, from the February 2023 issue of The Journal of Investing, Moshe Levy of Hebrew University and Richard Roll of Caltech introduce a metric for predicting US equity mutual fund performance that significantly outperforms the simple Shape ratio. They call their metric the “shrinkage-adjusted Sharpe ratio” (SAS) because it uses two adjustment factors to shrink past performance measures (e.g., average returns of an individual fund) toward their cross-sectional means (i.e., toward the average return of all funds). The adjustment factors apply to a fund’s gross returns but not to its fees. The authors assert that using the SAS rather than a simple Sharpe ratio as a basis for US equity mutual fund selection boosts risk-adjusted returns by roughly 1.1% per annum. The authors apply SAS to different asset classes (foreign equity and fixed-income funds) and time periods. They find that the performance is robust across both.