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When optimising for Sharpe ratio is not the same as optimising for wealth
Suhaimi Zainul-Abidin
Chief Executive Officer, Quantedge Capital
Over long horizons, investment outcomes are driven by one key force: compounding. The level of return that can be sustained over decades eventually outweighs the smoothness of those year-on-year returns. Despite a potentially more volatile path, a portfolio with a slight edge in annual returns may deliver significantly superior terminal wealth. This idea is simple, yet often overlooked — even by sophisticated investors — because much of the industry focuses on short-term risk measures, like the Sharpe ratio, which were never designed to judge long-term wealth creation.
The Sharpe ratio is a great tool for measuring investment performance. It offers a straightforward calculation of return per unit risk to easily identify the superior investment when comparing opportunities that generate identical returns. It is also useful as measure of the smoothness of returns over short periods.
However, when these conditions fail to hold, the Sharpe ratio can be limited, and in some cases misleading. A higher Sharpe ratio rewards lower volatility and more consistent returns, even if that consistency comes at the cost of lower overall growth. A portfolio can look safer on paper while quietly giving up the compounding power that ultimately determines long-term outcomes. Therein lies a limitation of the Sharpe ratio, as the more pertinent consideration for most investors is the actual potential for wealth creation over long periods.
Volatility and drawdowns feel decisive over short periods — but over decades, they rarely are. The longer the horizon, the less short-term fluctuations matter, and the more compounding dominates outcomes. A seemingly marginal advantage early on compounds into outsized gains with enough time. This is why long-term investment outcomes are often very different from what traditional risk metrics would have predicted at the start. The chart below makes this effect immediately clear.
Portfolios that are built to maximise the Sharpe ratio often have to sacrifice absolute returns. A high Sharpe strategy appears to be more efficient as it mathematically signals to investors that they are better compensated for every unit of risk taken, but this may come at the expense of total returns and exclude them from opportunities that drive long-term growth.
The most successful long-term investors have sought not to minimise volatility, but to maximise the value of capital in the long run. The difference matters. The real risk, in this context, is not defined by short-term fluctuations, but by the likelihood of failing to achieve sufficient long-term growth.
Metrics such as the Sharpe ratio can still play a role, but they are best used as constraints — tools to ensure a strategy remains investable — rather than targets to optimise. What ultimately drives outcomes is the rate at which capital compounds and the ability to remain invested through inevitable periods of discomfort. A strategy with smoother returns may experience fewer drawdowns, yet still end with significantly less wealth than a more volatile strategy that compounds at a higher rate.
Risk is not inherently undesirable in a portfolio, but a distinction should be made between compensated and unrewarded risk. For meaningful wealth creation, the former would be deliberately sought to capture the potential for excess returns. Investors who indiscriminately avoid risk forfeit the potential long-term returns that accompany it.
Even whilst we have established the necessity to embrace risk to compound returns meaningfully over the long term, it is important to recognize the dangers of both insufficient and excessive risk-taking, both of which can impede wealth creation.
While the transfer of risk in financial markets often compensates the risk-bearer with higher returns, the risk-reward relationship is not a linear one. The concavity illustrated below shows that returns decay with higher volatility. This can be attributed to the phenomenon known as volatility drag, which causes every additional unit of risk taken to yield diminishing returns. And more concerningly, volatility drag starts to accelerate faster than incremental returns when risk levels exceed a certain threshold, resulting in a net negative effect on returns. An excessively risky portfolio will be penalised instead of rewarded.
This is further exacerbated by the asymmetric nature of drawdowns that are unavoidable over long investment horizons. Extreme market events, albeit infrequent, can be disproportionately damaging to portfolios. If left unmanaged, such tail risks threaten long-term wealth accumulation.
The complex dynamic between risk and return underpins Quantedge’s investment approach. Quantedge diversifies to minimise idiosyncratic risk and gain exposure to compensated risks that exist across markets. This exposure is governed by a risk target, calibrated to balance return generation with the compounding costs of volatility. Two decades of experience across various market cycles have further informed our construction of the risk target, evolving beyond a simple volatility target into a proprietary combination of risk metrics for a more holistic measure of portfolio risk. Quantedge targets this constant level of total risk that we believe to be optimal to serve the dual purposes of:
• Risk management. Since returns do not scale infinitely with volatility, keeping to the risk target prevents the portfolio from inadvertently accumulating excess risk as a byproduct of external market volatility.
• Alpha generation. The fund maintains the necessary exposure for meaningful long-term capital growth by taking on a sufficient level of risk, especially when markets are calm.
The advantage of higher compounding strategies only materialises if investors remain invested through periods of volatility. In practice, this is where theory and reality often diverge. Strategies that maximise long-term returns may also test the conviction of investors along the way, requiring a tolerance for drawdowns and dispersion in possible outcomes. This does not diminish the merit of such strategies — it defines the true constraint. The challenge is not to eliminate volatility, but to align portfolio construction with an investor’s ability to endure its features. When that alignment is achieved, the full power of compounding can be realised; when it is not, even the best strategies can fail to deliver their potential.
Over long horizons, the most meaningful risk is not volatility, but the failure to compound capital at a sufficient rate. The objective is therefore not to minimise volatility or to maximize the portfolio’s Sharpe ratio, but to ensure that the strategy’s short-term outcomes are tolerable, allowing the full benefits of long-term compounding to be realised.
• National Stock Exchange of India. (n.d.). Historical index data. NSE India. https://www.nseindia.com/reports-indices-historical-index-data
This article is for general information and does not constitute investment advice.