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.
In this article
What is Sharpe Ratio?
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.
How to measure the Sharpe Ratio?
The Sharpe Ratio of any mutual fund can be easily calculated using a simple formula or by following these two steps:
- Subtract the risk-free return of a mutual fund from its portfolio return or the average return
- Divide the subtracted number, which is called the excess returns by the standard deviation of the fund’s returns.
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
What is considered a good 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.
Why is Sharpe Ratio important?
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.
- Risk-adjusted return calculator: With the Sharpe Ratio, investors can calculate the risk factors before starting investing in mutual funds. Existing investors can decide to transfer their investment if their present fund gains low Sharpe Ratio.
- Helps in fund comparison: Beginners can compare the Sharpe Ratios of different mutual funds to identify their risk factors and adjusted-return rates.
- Aids in comparing against the benchmark: Investors can compare their existing or preferred fund with the peer funds. Thus, investors can understand the performance of their existing or prefered funds.
- Analyse the fund’s performance: The Sharpe Ratio sheds light on a fund’s performance. By looking at this ratio, the investors can evaluate the level of risk of any fund in comparison with the extra returns. This calculator can be used to analyse funds operated with growth style, value style or a blend of both.
- Study the portfolio diversification: Investors can use the Sharpe Ratio as a tool for identifying the need for portfolio diversification. If an investor is invested in a fund with 2.00 Sharpe Ratio, then adding another fund to his portfolio would help in reducing the ratio and risk factor. Additionally, it will increase returns. But, in the case of a fund with a Sharpe Ratio of 1.00, adding another fund to the portfolio may not be ideal.
- Examine the risk and return rate: A fund with higher Sharpe Ratio is considered to have a higher return and higher risk as well. Therefore, investors aiming to earn higher returns tend to opt for funds with a high ratio. But the intake of additional volatility can change the equation. A fund having 5% returns with moderate volatility is always better than a fund having 7% returns with high volatility.
Limitation of Sharpe Ratio
Despite various advantages, the Sharpe Ratio has few limitations, which are mentioned below:
- Sharpe Ratio of a fund does not take responsibility for portfolio risk and does not reveal whether the fund is dealing in single or various sectors.
- It considers all the investments to have a normal pattern for the dispersion of returns, but funds may have different dispersion patterns.
- Comparing the Sharpe Ratio of two or more funds only shows the risk-adjusted returns.
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.