The highest sharpe ratio portfolioi in User portfolios holds only ultrashort treasuries and show a sharpe ratio of 7+. But my understanding is the Sharpe ratio is the return less the risk-free rate divided by the standard deviation of returns. But short-term treasuries ARE the risk free rate, so the Sharpe ratio should be zero since the risk free rate minus the risk free rate is zero. So are you simply ignoring the risk-free rate and dividing returns by the standard deviation???

Addendum:

Just input my portfolio and asked that your site optimize it for Sharpe ratio. I have ready cash in USFR, and ETF that holds US floating rate notes exclusively. The optimization recommended I put over 99% in USFR. However, the interest rate on floating rate notes is based on the three month treasury, so again, USFR has a Sharpe ratio of zero! Please correct this!

Hi Bob, as you've noted, the typical calculation of the Sharpe ratio involves subtracting the risk-free rate from the investment's return. So, in situations where the investment's return matches the risk-free rate, the Sharpe ratio would generally be close to zero.

However, our approach differs slightly. By default, we use a 0% risk-free rate, considering that the risk-free rate can vary significantly across different regions. While U.S. Treasuries are a standard benchmark in the United States, they may not be appropriate in other areas due to factors like regulatory, tax, or currency risks. Therefore, selecting a specific government security as a risk-free benchmark can depend on the investment horizon and the country of analysis. As we calculate the Sharpe ratio for thousands of portfolios and instruments across various markets, we've opted for a 0% risk-free rate as a conservative and broadly applicable default.

If you need more configuration options, you can use our Sharpe ratio calculator. This tool allows you to choose a specific risk-free rate and other parameters that better suit your preferences. It's especially useful in scenarios where our default risk-free rate might not be the most appropriate for your needs.

I hope this explanation clarifies our methodology. If you have any more questions, feel free to reach out!

Thanks Dmitry. That's very helpful. Zero as a risk-free rate worked very well for many years since short-term treasuries yielded very close to zero. It now really screws up allocations between stocks and bonds, though. I would also say short-term treasuries are an appropriate risk-free rate regardless of your time horizon. If you go out the yield curve, you are introducing duration risk so longer rates are no longer risk-free. We can see how volatile the prices have been for 10 year treasuries!

Still, I understand introducing a meaningful risk-free rate is difficult, and the risk-free rate is dynamic, not static. I'll subscribe and play with the workaround you suggested. Thanks for the response!