Several specific situations render the Sharpe Ratio unreliable or misleading:
Strategies with extremely small samples. Sharpe Ratios calculated over fewer than 24 monthly observations have wide confidence intervals. A “stellar” Sharpe Ratio from a 2-year-old fund may not survive longer measurement periods.
Strategies with non-stationary returns. When the underlying return distribution changes over the measurement period – regime shifts, structural breaks, evolved trading approaches – the standard deviation in the denominator becomes a mathematical average across different regimes rather than a coherent risk measure.
Strategies with path-dependent returns. Options strategies, drawdown-conditional rebalancing, and similar approaches produce returns that depend on the sequence of prior returns, not just the current return distribution. Sharpe Ratio assumes return independence, which fails for these strategies.
Strategies with embedded leverage that varies. A strategy whose leverage changes through time has a Sharpe Ratio that is essentially an average across different leverage levels – not informative about any specific level.
Strategies with significant illiquidity premium. Private equity, real estate, and other illiquid investments produce artificially smoothed returns. Reported Sharpe Ratios should be heavily discounted relative to mark-to-market liquid equivalents.
In these situations, supplement Sharpe with maximum drawdown, expected shortfall (CVaR), scenario analysis, and qualitative strategy assessment.