Executive Insight
The standard Sharpe ratio is the most widely used risk-adjusted performance metric in institutional fund evaluation. However, it has a well-known instability: when portfolio volatility approaches zero (as in money-market or low-vol arbitrage funds), the ratio explodes to meaningless values. This note presents two modifications—the volatility-floor Sharpe and the Fynup ratio—that correct this instability while preserving cross-sector comparability for fund ranking.
Core Framework
The modified Sharpe ratio replaces the standard deviation denominator with a floored estimate:
where $\sigma_{\min}$ is typically set to 3% (annualized). This ensures that near-zero-volatility funds receive bounded scores. The floor value of 3% is calibrated as the 5th percentile of realized annual volatility across 33,030 funds in the source dataset spanning 25 Morningstar sectors.
The Fynup ratio is a ranking-oriented metric that combines return persistence, drawdown recovery, and cost efficiency into a single composite score normalized to [0, 100]. It penalizes funds with high volatility-of-returns (inconsistency), slow drawdown recovery (fragility), and high expense ratios (cost drag). The composite weighting is: 40% return persistence, 30% drawdown recovery speed, 30% cost efficiency.
Applied Example
In the source study of 33,030 funds, the top-quintile quality class defined by the modified Sharpe shows 68% persistence over the subsequent 3-year window, compared to 41% for random assignment. The Fynup ratio achieves similar persistence (65%) while additionally penalizing funds that achieve high Sharpe through leverage (which inflates returns but deepens drawdowns). The two metrics agree on 78% of top-quintile assignments, with disagreements concentrated in leveraged and alternatives categories.
Implications
Institutional fund selectors should replace the raw Sharpe ratio with the modified version for any screening exercise involving mixed asset classes. The 3% volatility floor is a conservative default; organizations with stronger views on minimum-volatility thresholds can adjust. The Fynup ratio is recommended as a secondary ranking metric for governance committees that require a single composite quality score incorporating cost and consistency dimensions beyond the Sharpe.
Derived from From Equations to Capital research program, by Mourad E. Mazouni, PhD, PMP. View Volume I →