Sharpe Ratio plays a significant part in evaluating the performance of an investment. Developed by American economist and Noble laureate William F. Sharpe, the Sharpe Ratio measures the risk-adjusted returns of an investment. Sharpe Ratio can be taken into account before starting investing in any fund. However, it is necessary to understand all the aspects of this ratio before using it for evaluating or comparing mutual funds.
Sharpe Ratio of a mutual fund reveals its potential risk-adjusted returns. The risk-adjusted returns are the returns earned by an investment over the returns generated by any risk-free asset such as a fixed deposit. However, higher returns indicate extra risk. Higher Sharpe Ratio means greater returns from an investment but with a higher risk level. Therefore, it justifies the underlying volatility of the funds. The investors aiming for higher returns will have to invest in funds with higher risk factors.
The Sharpe Ratio of any mutual fund can be easily calculated using a simple formula or by following these two steps:
Standard Deviation: Standard Deviation reveals how much the investment return varies from the principal returns of an investment. A high Standard deviation indicates a huge difference between the returns and the principal returns of an investment.
Suppose the annual Sharpe Ratio of a fund is 1.00. The excess returns generated by the fund during the same time horizon, therefore, is 1.00%. Funds with higher Standard Deviation earns higher returns making the Sharpe Ratio high. However, funds with low Standard deviation can earn high Sharpe Ratio as well, provided it consistently earns a moderate return. Sharpe Ratio can be calculated monthly or can be annualised.
Given below, is the Sharpe Ratio formula:
|Excess Returns (Average returns-Risk-free returns) / Standard Deviation of Fund Returns
= Sharpe Ratio
|Sharpe Ratio||Risk Rate||Verdict|
|Less than 1.00||Very low||Poor|
|1.00 – 1.99||high||Good|
|2.00 – 2.99||high||Great|
|3.00 or above||high||Excellent|
The table shows the features or parameters of a good Sharpe Ratio. Investments with less than 1.00 Sharpe Ratio do not generate high returns. Contrarily, investment with Sharpe Ratio of 1.00 to 3.00 or above have higher returns subsequently.
The place of Sharpe Ratio in mutual funds is of great significance. It helps investors in recognising the risk level and adjusted-return rate of mutual funds. Therefore, investors get to know if the high risk taken by them is generating good outcomes.
Despite various advantages, the Sharpe Ratio has few limitations, which are mentioned below:
Moreover, the Sharpe Ratio can be influenced by the portfolio managers. They can try to boost their risk-adjusted returns by lengthening the time horizon for measuring the ratio. Depending on the Sharpe Ratio only, to evaluate a mutual fund will not be a good strategy. This ratio reveals limited information.
Multiple funds are operating in India. Choosing a mutual fund can be a hard task, especially for beginners and those with less market knowledge. These individuals can use tools like the Sharpe Ratio to evaluate or compare the mutual funds. One can find the Sharpe Ratios of different mutual funds easily online. Sharpe Ratio of Indian mutual funds can act as a tool of evaluation, but it can’t be the only parameter. To analyse all the influencing factors of any mutual fund, one should use other measuring instruments as well.