Which of the following is a limitation of the Sharpe ratio?

The Sharpe ratio, which measures the risk-adjusted return of an investment, is particularly sensitive to the characteristics of the return distribution. One key limitation is its lack of predictive ability for hedge funds, which often employ complex strategies and can have non-normal return distributions. Hedge funds might exhibit returns that are skewed or exhibit kurtosis, which the Sharpe ratio does not adequately capture, thereby making it a less reliable measure for evaluating their performance.

Unlike traditional investments that tend to follow a bell curve in terms of return distributions, hedge funds can have significant returns that deviate from the norm. This non-normality can lead to misleading interpretations when using the Sharpe ratio in a hedge fund context, whereby the ratio might indicate that a hedge fund has a low risk adjusted return, even when the manager is employing strategies that, although risky, can generate considerable long-term alpha.

In addition, the Sharpe ratio assumes that returns are additive and can fail to account for the full dynamics of investment strategies that hedge funds typically exploit. Thus, the ratio's applicability to hedge funds, which often aim for absolute returns regardless of market conditions, is limited.

In contrast, for other types of investment funds, such as equity funds, the Sharpe ratio may