What is the Sharpe Ratio? What does the Sharpe Ratio measure?

What is the Sharpe Ratio? What does the Sharpe Ratio measure?

Sharpe Ratio in Mutual Funds: An Overview

Sharpe ratio is named after Willian Sharpe, an American economist 1996. Sharpe ratio is used to analyze the performance of securities. It helps investors to gauge the risk-adjusted returns of their investment. It is considered that the higher the Sharpe ratio is, the more return on investment is expected in proportion to the amount of risk taken. Mainly, the Sharpe ratio tells you how much additional return you are likely to get on investing in a risky asset. In this article, we are going to learn about the Sharpe ratio, the Sharpe ratio formula, how to calculate the Sharpe ratio in a mutual fund, and the benefits of the Sharpe ratio. 

What is the Sharpe ratio?

Various fundamental ratios help a fundamental investor to analyze a stock and the Sharpe ratio is one of the most used ratios to gauge the potential return of a mutual fund or securities  The Sharpe ratio is used to analyze the additional return you are likely to get on the securities concerning its risk. It helps to find out the extra profit earned because of the risk taken. The Sharpe ratio is used to track the history of a portfolio or analyze past returns. 

Sharpe ratio helps you to acknowledge the additional return on the security above the benchmark return concerning taken risk. Basically, a benchmark acts as a standard to compare the performance of a security with its peer. For example, if you have invested in an auto stock and the annual return you received is 12% meanwhile the Nifty auto has given 15%. it means that your invested stock has not beaten the benchmark. 

Let's understand the role of the Sharpe ratio. Let's say, ABC Mutual fund has given a 15% return annually and XYZ mutual Fund has given 17% returns annually. Both are equity funds but XYZ mutual funds have given a better return than the other which makes them more attractive to investors. Now let us talk about its risk factors. The standard deviation of ABC mutual funds is 17% and the standard deviation of XYZ mutual funds is 42%. Investors can find XYZ mutual fund most attractive and find it a good investment option as it offers higher returns. However, it is also associated with high risk and it can backfire on you during market fluctuations. This is where the Sharpe ratio calculator is used to gauge risk-adjusted returns. 

Sharpe Ratio in Mutual Funds: Key Takeaways

  • The Sharpe ratio calculation is based on historical data and hence, it does not guarantee future returns. 
  • It is used to gauge risk-adjusted returns. 
  • Sharpe ratio tells you how much extra returns you can get by taking extra risk. 

What is the formula for Sharpe ratio calculation? 

For calculating Sharpe ratiodiminish the risk free gain from the investment return, and then calculate the extra gain. After that, the extra return has to be divided by the standard deviation.
Sharpe ratio = (return on investment - risk free rate of return) / standard deviation  

Return on investment can be daily, weekly or monthly and the risk free rate of return is the return gained from less risky investments such as bonds. If the Sharpe ratio is higher, it is considered good.

What does the Sharpe Ratio tell us?

  • Comparison of funds: Sharpe ratio can be used to evaluate and compare mutual funds. It helps you to know the risk level and the rate of return of a mutual fund. Understanding the risk level you are going to take on an investment will make sense if the rate of return is good. Using a Sharpe ratio in mutual funds will help you to analyze mutual fund performance in terms of growth and returns. 
  • Understanding of risk level: Using of Sharpe ratio in mutual funds tells you the risks associated with mutual funds. Moreover, if your current investment has a low Sharpe ratio you can transfer your investment. 
  • Compare against the benchmark: Sharpe ratio helps investors to compare the existing investment with the benchmark. If the existing investment is not performing well as the benchmark, you can transfer your investment. 
  • Understanding of funds operation: The Sharpe ratio tells you how the fund is performing. Investors can get an understanding of how much risk they are willing to take to get that extra return from the mutual fund investment. 
  • Evaluating the risk and return rate: It is considered that a higher Sharpe ratio is good as compared to a lower Sharpe ratio. So, if your mutual fund has a higher Sharpe ratio, investors are more likely to earn higher returns. 

Things to keep in mind while using the Sharpe Ratio

  • The Sharpe ratio can be inaccurate at times because the returns on investment are unequally distributed. However, you can use the Sharpe ratio to evaluate the portfolio in the long term. 
  • Using a Sharpe ratio can show wrong results in the short run if there is any immediate movement in price. 
  • Sharpe might not be useful if you are using it for evaluating a single sector as it will make sense if you compare it with its benchmark. 
  • Investors can use the Sharpe ratio as well other fundamental ratios to evaluate past returns of a security. Since fundamental analysis or technical analysis is based on the past and hence, it can guarantee future returns. 
  • Fund managers can operate the Sharpe ratio by changing the time frame to show a false image. 

Bottom line 

Sharpe ratio is one of the most effective metrics to measure the risk of a security and evaluate mutual funds. Sharpe ratio can be used by fundamental investors and portfolio managers to make informed decisions on investment. Sharpe ratio can be used to compare different funds and can give you an understanding of additional returns you can get from a portfolio with respect to its volatility. However, one should not rely solely on the Sharpe ratio to make investment decisions. You should also consider other fundamental ratios such as debt to equity ratio, earning per share, return on equity, price to earning ratio, and working capital ratio to make your investment decisions. 

  • Can I use the Sharpe ratio to assess a single investment?

  • What is a good Sharpe ratio?

  • What is the Sharpe ratio formula?

  • When should I use the Sharpe ratio while evaluating stocks?