How to Read a Sharpe Ratio

The Sharpe Ratio is the most widely used metric for measuring risk-adjusted investment performance. Developed by Nobel Prize winner William Sharpe in 1966, it answers a fundamental question: how much return are you getting per unit of risk taken? But many investors misread it — here's a complete guide.

The Formula Explained

Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation of Portfolio Returns. The numerator is the excess return (what you earn above the risk-free rate like T-Bills). The denominator is the standard deviation, measuring total volatility. A higher Sharpe Ratio means more return per unit of risk.

What is a Good Sharpe Ratio?

General benchmarks: Below 0.5 = poor (you could likely do better with less risk), 0.5-1.0 = acceptable, 1.0-2.0 = good, Above 2.0 = excellent (rare and often unsustainable). The S&P 500 long-term Sharpe Ratio is approximately 0.4-0.5. GEM strategy: ~0.72. A diversified All Weather: ~0.60.

Sharpe Ratio Limitations

The Sharpe Ratio has important limitations. It penalizes upside volatility equally with downside volatility, which is unfair — investors don't mind volatile gains, only volatile losses. This is why many quant investors prefer the Sortino Ratio, which only penalizes downside deviation. Additionally, Sharpe Ratios calculated over short periods can be misleading.

"Dual momentum is the clean integration of relative strength momentum and trend following absolute momentum. They complement each other perfectly." — Gary Antonacci

The GEM Execution Rules

GEM is rebalanced exactly once per month. At the end of each month, the investor carries out the following steps:

1. Calculate the trailing 12-month return of S&P 500 (representing US stocks) and MSCI ACWI ex-US (representing global stocks).
2. Select the index with the higher return.
3. Compare the return of this winning index to the trailing 12-month return of 1-3 Month Treasury Bills (cash proxy).
4. If the winning equity return is greater than cash, invest 100% in that equity index. Otherwise, invest 100% in a broad U.S. Aggregate Bond index (like BND or AGG).

Why GEM Works

Historically, equities spend about 70-80% of the time in bull markets. Relative momentum keeps the investor aligned with the strongest equity markets (whether that's US tech stocks or international value plays). However, when severe bear markets emerge (such as the 2008 financial crisis or the 2000 dot-com crash), absolute momentum acts as a circuit breaker, moving the entire portfolio into high-quality bonds. This reduces drawdown risk and protects capital.

ETF Implementations

A typical retail investor can implement GEM using just three low-cost, liquid ETFs:

• US Stocks: Vanguard S&P 500 ETF (VOO) or SPDR S&P 500 ETF (SPY)
• International Stocks: Vanguard Total International Stock ETF (VXUS) or iShares Core MSCI ACWI ex U.S. ETF (ACWX)
• Aggregate Bonds: Vanguard Total Bond Market ETF (BND) or iShares Core U.S. Aggregate Bond ETF (AGG)