CFA Level I · CFA Level I Exam · Alternative Investment Performance and Returns
A hedge fund reports monthly returns with a true standard deviation of 4.0%. Because of stale pricing, returns show a first-order autocorrelation of 0.50. Relative to the true risk, the reported Sharpe ratio is most likely:
The reported Sharpe ratio is most likely overstated. Stale pricing creates positive autocorrelation that smooths returns and understates measured volatility, and since volatility is the denominator, risk-adjusted performance looks better than the true economics.
- AOverstated because reported volatility is understatedCorrect
- BUnderstated because reported volatility is overstated
- CAccurate because autocorrelation affects only the mean return
Explanation
Positive autocorrelation from smoothed or stale prices lowers measured standard deviation, particularly when annualized with the square root of time. A smaller denominator inflates the Sharpe ratio, so the reported figure overstates risk-adjusted performance.
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