Reinterpreting the Sharpe Ratio as a Measure of Investment Return from Alpha

Abstract

This paper examines the fundamental building blocks of the Sharpe ratio to debate over the economic interpretation of this well-known tool used to measure the risk-adjusted performance of various financial portfolios and funds. It focuses on the risk-adjusted expected return of an investment versus a benchmark portfolio (or index) return. By leveraging on a set of statements and assumptions, I isolate the information content of the ratio as expression of the investment return from alpha. I finally derive that, under the efficient market hypothesis ( EMH ) or perfectly diversified portfolios, the Sharpe ratio is zero.