Most of you know who a fund manager is and how critical he/she is to a particular mutual fund scheme.

For those of you who don’t, let me explain it to you.

Fund manager is the one who takes investment decisions on behalf of you. Literally.

What does a fund manager do?

These are the two main responsibilities of a fund manager

1.Taking investment decisions regarding the scheme

They are responsible for implementing a fund’s investing strategy which is in line with the objectives of the fund and they manage the fund’s portfolio on a day to day basis.

You can say that the fund manager looks after your funds and takes the investing decision on your behalf to attain consistent returns with a particular level of risk.

2.Monitoring the market

The fund manager monitors the market, economic trends and tracks securities.

He/She reviews the financial result of various companies and decides which stock will be included in the portfolio to accomplish the aims of the mutual fund.

How can you evaluate a fund manager?

A person who plays such an important role in managing our funds must be evaluated adequately.

The question here is how to evaluate the performance of the fund manager?

As most of you know, finance and investing is all about strict discipline.

Hence, financial academics has come out with various quantitative parameters which helps to compare different funds and their performance.

Among these tools, one is ratios. They include standard deviation, Sharpe ratio, etc.

What is Sharpe Ratio?

According to Investopedia, Sharpe ratio is defined as, “average return earned in excess of the risk-free rate per unit of volatility or total risk”

Confused? So are we.

We all know these terms are very difficult to understand. So, we’ll try to break down the terms for you.

First, risk-free rate?

Risk free rate is defined as the purchase of (almost) zero risk securities such as government bond etc. So, this is the minimum return which you should be compensated with, as there is no risk involved.

So, if you have to find out how much you have earned, it must be considered over and above this risk free rate.

Let us call this difference  (actual return on fund manager’s portfolio and risk free rate) as excess rate of return.

Now, how do you know that the excess rate of return is at par with the risk you’ve taken?

For this, you divide the excess rate with excess risk taken. Thus, Sharpe ratio can be said to be the extra return per unit of risk.

So basically, if the fund is a small cap equity fund, then the deviations in the daily returns will be very high, increasing the volatility and hence, the denominator in the ratio.

This in turn will reduce the overall Sharpe ratio.

This basically implies that more the Sharpe ratio (also called reward to risk ratio) the more is your reward at the same risk taken.

In simple terms, Sharpe ratio is the process of examining the performance of an investment, by adjusting the risk.

This is why Sharpe ratio is one of the most important factors to benchmark a fund’s performance over time.

How will you evaluate a fund manager’s performance using Sharpe ratio?

The following are the areas which is covered by Sharpe ratio that can be of big help to you while judging a fund manager’s performance.

1.Optimum risk-adjusted return

Sharpe ratio is a comprehensive mechanism to measure the performance of a fund against a given level of risk.

Higher the Sharpe ratio of a portfolio, the better is its risk-adjusted returns and the fund manager’s performance.

However, if you obtain a negative Sharpe ratio, it means that you would be better off investing in a riskless asset, than the one you are invested in right now.

2.Fund comparison

Sharpe ratio can be used as a tool to compare the performance of the fund which is placed in the same category like analyzing the conduct of Fund A and Fund B (both belonging to the same category).

In this way, you can ensure that both funds are facing a similar level of risk and compare their returns which depend on the choices made by the fund manager.

Conversely, you might also compare funds giving similar returns but which are at different levels of risk.

3.Comparison against benchmark

Sharpe ratio can tell you whether the preference of the fund manager is suitable from an investment perspective, as compared to peer funds in the said category.

You may even broaden your horizon by comparing the fund’s Sharpe ratio with that of the underlying benchmark.

In this way, you can know whether your fund manager is outperforming/underperforming the benchmark. Ultimately, you get to know how well you are being compensated for the risk that you are taking in the investment.

4.Analyzing the fund’s strategy

Sharpe Ratio is one of the most powerful tools used in selecting a mutual fund.

As it is entirely quantitative in nature, it provides objective feedback into a fund’s performance.

By looking at the Sharpe ratio, you can assess the extra returns over the risk-free returns.

In fact, it is a standardized tool to compare funds which use different strategies like growth or value.

Sharpe ratio is the most important factor to look before investing, but definitely, not the only factor to be considered. You should know that it is just a number and can be properly interpreted when compared with other funds.

Conclusion

Further, Sharpe ratio doesn’t indicate whether the portfolio consists of a single sector.

If the funds are invested in just one sector of the market and that sector is performing well, then you will earn high returns and thus, you will have a high Sharpe ratio.

But, don’t blindly rely on the Sharpe ratio. Use other financial tools and take an informed decision.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww