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To compare my stock portfolio generator with managed funds performance, I want to calculate the Sharpe Ratio of my historic portfolios with the numbers found on the fund company web sites or in financial portals. However, I could not find a specification of their calculations. I also emailed MorningStar to no avail.

Question 1: What exactly should be used for risk-free interest? I can use the 12M USD LIBOR but it is at least 1% below the risk-free interest a private investor can expect (I am looking for a one year performance, i.e. hold all stocks exactly one year).

Question 2: I am using LOG10(day /day before) returns for the stdev calculation, but for the return calculation I use last portfolio value - first portfolio value - 1.0. That is probably total bogus and makes my numbers look too good but since I could not find a reference... I might as well use geometric averages or dollar amounts as was suggested in one answer to a similar question here, but what is the official way of doing it?

So my main question is: how exactly do the fund companies calculate the Sharpe Ratio? I also heared the opinion that they do it this way or the other, whatever suits. But that would make the Sharpe Ratio worthless for comparing fund performance, so there must be one accepted method?!

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Every company I've ever worked for ignores the risk-free rate and just computes $\frac{\mu}{\sigma}$ using daily returns. Of course, this number is then multiplied by $\sqrt{252}$ to annualize. –  chrisaycock Jun 30 '13 at 20:23
    
Good info, thank you, this makes sense when the ratio is used to compare portfolios. The interest would not provide much information but an error source. I just never heard that the interest can be omitted before. –  TvdH Jul 4 '13 at 14:40
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1 Answer

up vote 4 down vote accepted
  1. Make your pick depending on your market, but make it EXPLICIT. As chrisaycock noted, most companies ignore the riskfree rate, and usually thats fine, Sharpe-ratios are almost exclusively interpreted in comparison. If clients demand sharpe ratios (and require a risk-free rate), just make sure it is totally clear which one you've used.

  2. No 'official' way, whatever floats your boat. This looks good to me though. Make it explicit, e.g. via footnote.

You get the idea: Spell all assumption/methods, and nobody can complain.

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