Sharpe Ratio

The ratio was created by William F. Sharpe in 1966. He also won a Nobel Memorial Prize in Economic Sciences in 1990 for his contribution towards the origin of the CAPM – Capital Asset Pricing Method. Sharpe ratio is derived from the CAPM model.

The Sharpe Ratio is the difference between the risk-free return and the return of an investment divided by the investment’s standard deviation. In simple words, the Sharpe Ratio adjusts the performance for the excess risk taken by an investor. However, the investor can measure if the investment aligns his requirements with the Sharpe Ratio.

The higher the ratio, the greater the investment return relative to the amount of risk taken, and thus, the better the investment. The ratio can be used to evaluate a single stock or investment, or an entire portfolio.

How to calculate Sharpe ratio?

The Sharpe Ratio of a mutual can be easily calculated by using a simple formula or by following these two steps mentioned below;

1. Subtract the risk-free return of a mutual fund from its portfolio return or the average return

2. Divide the subtracted number, which is called the excess returns, by the standard deviation of the fund’s returns.

Standard Deviation- Standard deviation showcases the investment return that varies from the principal returns of an investment.

A high standard deviation means there is a huge difference between the principal returns and the returns of an investment.

For example-

The annual Sharpe Ratio of a fund is 2.00. The more returns generated by the fund during the same time will be 2.00%.

A fund having a higher standard deviation makes higher returns as their Sharpe Ratio is considered high. However, funds with a low standard deviation can earn High Sharpe Ratio and give consistent moderate returns.

Sharpe Ratio can be calculated annually or on a monthly basis.

Formula–

Share Ratio =  RP-RF/SD

Where,

RP- portfolio return

RF- risk-free rate of return

SD- standard deviation of portfolio’s excess returns

The below-given table shows the indicators of the good and bad Sharpe Ratio. Investments having less than 1.00 do not generate higher investor returns.

However, investments with Sharpe Ratio between 1.00 to 3.00 are considered great Sharpe Ratio and investments above 3.000 are considered excellent Sharpe Ratio.

Example of how to use the Sharpe ratio

Let’s assume an investor currently has a portfolio of Rs 5 lakh with an expected return of 10% and a standard deviation of 8%. What would be the Sharpe ratio if the risk-free rate of return is 5%?

Sharpe ratio = (10-5)/8 = 62.5%

In this example, our excess return is 5% (Portfolio return – Risk-free return) and risk/SD is 8% which gives us a Sharpe ratio of 62.5%.

Importance of Sharpe ratio

• Analyse the fund’s performance- The Sharpe Ratio help’s investors to shed light on a fund’s performance. By looking at Sharpe Ratio, investors can carry out the level of risk of any fund in comparison with the extra returns. It is majorly used to analyse mutual funds operations with both growth and value style.

• Study The Portfolio Diversification- With the help of the Sharpe Ratio, investors can use it as a tool to identify the need for portfolio diversification.

Suppose, if an investor is invested in a fund with a Sharpe Ratio of 2.00, adding other funds to the portfolio would help reduce ratio and risk factors.

• Helps in Fund Comparison- Beginners have the opportunity and can compare the Sharpe Ratios of various mutual funds to analyse their risk factors and adjusted-return rates.

• Investors Can Calculate the Risk Factor- with the Sharpe Ratio, investors can easily calculate all the risk factors before investing in mutual funds. In addition, existing investors can also decide to transfer their investment if their present fund gains a low Sharpe Ratio.

• Examine The Risk and Return Rate- A fund having a higher Sharpe Ratio is considered great because it gives higher returns and higher risk. Therefore, investors looking to earn higher returns tend to opt for a fund that comes with a high ratio.

However, it can change the equation because a fund giving 5% returns with moderate volatility is always better than a fund having 7% returns with high volatility.

Limitations of Sharpe ratio

• It considers all the investments to have a normal pattern for the dispersion of returns, but funds may have different dispersion patterns.

• The portfolio managers influence the Sharpe Ratio. They can try to boost their risk-adjusted free returns by lengthening the time horizon for measuring the ratio.

• Sharpe Ratio of a fund does not take any responsibility for managing portfolio risks and does not reveal whether the fund is dealing with single or multiple factors.

• Sharpe Ratio is used to evaluate a mutual fund which is considered not a good strategy.

Overview

Several funds are operating in India, and selecting a mutual fund can be challenging, especially for newbies with less market knowledge.

These individuals can take the benefit of using the Sharpe Ratio to compare or evaluate the mutual funds. Thus, the Sharpe Ratio of mutual funds acts as an evaluation tool, but it can’t be the only single parameter.