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FRM Part II · FRM Exam Part II · Illiquid Assets

A risk committee compares Sharpe ratios for a private real estate fund using reported returns versus unsmoothed returns. Which outcome is most likely?

The Sharpe ratio from reported returns is overstated. Smoothing barely changes the average return but lowers measured volatility, so dividing by a smaller standard deviation inflates the ratio compared with one computed from unsmoothed returns.

  1. AThe Sharpe ratio based on reported returns is overstated relative to the unsmoothed oneCorrect
  2. BThe Sharpe ratio based on reported returns is understated because of lower mean return
  3. CBoth Sharpe ratios are identical because unsmoothing changes only skewness
  4. DThe reported Sharpe ratio is lower because autocorrelation increases measured volatility

Explanation

Smoothing leaves the average return broadly unchanged but reduces measured volatility. With the same numerator and a smaller denominator, the reported Sharpe ratio is inflated. Unsmoothing raises volatility and lowers the ratio.

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