Modified Sharpe Ratio

The modified Sharpe ratio is an extension of the original Sharpe ratio amended to include skewness, kurtosis and abnormal data. It is calculated by dividing the excess returns by the modified value at risk.

A higher return for a given level of risk can be expected from the investment with the higher modified Sharpe ratio. An investment may appear to yield higher returns, making it more desirable; however, the investment may be unstable and simply reflecting a high-risk result. The ratio is useful because many volatile investment vehicles are not normally distributed.

The original Sharpe ratio is most effective when assets are normally distributed or when investors have a quadratic utility function. This means that a portfolio is completely described by its mean and volatility. These simplifying conditions do not hold when a portfolio is invested in technology stocks, distressed companies, hedge funds or high yield bonds; there the basic Sharpe ratio is no longer valid. In this case, risks come not just from volatility but higher moments like skewness and kurtosis as well.

In short, the modified Sharpe ratio can adjust the measure to account for asymmetric factors, brought on by options and other directional exposures exhibiting non-normal returns, such as hedge funds.

The Sharpe ratio is a standard measure of portfolio performance. Due to simplicity and ease of interpretation, it is one of the most popular indexes. To get around the limitations of the standard version, the modified Shape ratio adds another layer of mathematical rigor.