Sharpe Ratio: Meaning, Formula, Benefits and Other Important Points
Mutual fund investments are always associated with certain levels of risk. As a result, financial advisors recommend that investors thoroughly evaluate their risk profiles before deciding on an appropriate investment. The return-generating potential of an investment may not by itself portray the right picture unless the risks associated with the investment are also taken into account. Therefore, it is advisable that investors also check the risk-adjusted returns that a fund generates.
The relationship between risk and return can be measured using the Sharpe ratio. In mutual funds, the Sharpe ratio is a metric that helps people understand how much extra return they will earn for taking a certain amount of risk.
What Is the Sharpe Ratio in Mutual Funds?
American economist William F Sharpe is famous for his work on the capital asset pricing model (CAPM), a financing theory that explained the relationship between risks and returns. While researching, he developed a ratio that compares and quantifies the potential returns of an investment with respect to its risk levels. This ratio came to be known as the Sharpe ratio.
In simple words, the Sharpe ratio helps investors understand how much return a mutual fund has generated against every unit of risk that it took. It uses the returns from a risk-free investment to calculate the fund’s risk-adjusted performance. Therefore, a fund that has a higher Sharpe ratio is considered to be superior to similar funds in the same category.
How to Calculate Sharpe Ratio?
To calculate the Sharpe ratio of a mutual fund, the risk-free rate of return has to be first reduced from the expected return of the mutual fund. The resulting figure is the excess return expected to be generated by taking the risk of investing in the mutual fund. The excess return, when divided by the standard deviation of the fund’s returns, gives the Sharpe ratio of the fund.
Given below is the formula for calculating the Sharpe ratio:
Sharpe ratio = (Rp-Rf)/SD of fund’s returns
Here, R(p) = Historical returns of a fund. The longer the time period, the better the Sharpe ratio’s accuracy.
R(f) = Risk-free returns (usually noted from 91-day Treasury Bill)
SD = Standard deviation of a fund’s returns depicts the volatility in the fund’s returns for a given timeframe
Please note that the Sharpe ratio of a mutual fund is calculated monthly, after which the data gets annualised to help people to understand better. Investors can easily find information about this ratio in the fund fact sheets.
What Is a Good Sharpe Ratio?
The following table displays various parameters of a good Sharpe ratio:
|Sharpe Ratio||Risk-adjusted Returns|
|Less than 1.00||Moderate|
|1.00 to 1.99||Good|
|2.00 to 2.99||Very Good|
|3.00 or Above||Excellent|
The table illustrates that schemes with a Sharpe ratio of less than 1 do not generate high returns. However, funds with a Sharpe ratio between 1.00 and 3.00 generate comparatively higher returns.
Let us use an example to understand the Sharpe ratio concept better. The table below provides information about two mutual funds, A and B.
|Mutual Fund||Expected Returns||Risk-Free Rate||Standard Deviation||Sharpe Ratio|
From the data given above, if we compare the expected returns of the two funds, we would see that fund A has invariably performed better than fund B. But, after considering the risks associated and computing the Sharpe ratio, we find that fund B has performed better.
This data indicates that Fund B has generated better risk-adjusted returns. Hence, it is a better investment option as its Sharpe ratio is greater than that of fund A.
What Are the Benefits of Using the Sharpe Ratio?
Now, let us look at the reasons why the Sharpe ratio is so significant in mutual funds:
- Sharpe ratio is of great help to people who are foraying into investments for the first time. Comparing the Sharpe ratio of various mutual funds enables beginners to better understand a fund’s performance, especially the risk and risk-adjusted return rates.
- Sharpe ratio of a mutual fund lets people understand whether the risk levels of the fund match their risk-taking-ability. It also helps investors in making vital decisions, such as transferring investments if the fund’s Sharpe ratio suddenly falls.
- Checking the Sharpe ratio helps people decide whether they need to diversify their portfolios. For example, if Ram invests in a mutual fund with a 2.00 Sharpe ratio, he should consider investing in another fund that has the same Sharpe ratio but lower associated risks.
- Comparing the Sharpe ratios of various funds provides a clearer picture of whether a fund is underperforming or outperforming. This, in turn, helps investors understand how well a fund performs with respect to the risk it has taken.
What Are the Limitations of Sharpe Ratio?
Though Sharpe ratio has many benefits, it is not devoid of limitations. So let us take a look at its limitations:
- Sharpe ratio of a mutual fund does not disclose whether the fund deals with a single sector or multiple sectors.
- When calculating this ratio, one has to assume that every investment has a normal pattern for the dispersion of returns. However, the dispersion patterns of different funds may vary.
- A major limitation of the Sharpe ratio is that it is based on standard deviation, which considers both positive and negative deviations from average returns. If positive deviations are high, it may lead to a higher standard deviation, indicating that the fund is risky. But, in reality, that may only sometimes be the case.
Important Points Regarding Sharpe Ratio in Mutual Funds
Listed below are some crucial points that would be helpful for investors:
- Investors need to be mindful of assessing the Sharpe ratio of a fund along with its standard deviation. It must not be evaluated all by itself.
- Investors must remember that different sources might put forward different Sharpe ratios for the same fund. So, they must carefully select and stick to a reliable source while comparing various funds.
- It is a good idea to use the Sharpe ratio to compare those funds that belong to the same category and share similar investment objectives.
- While comparing Sharpe ratios may enable investors to make a better investment decision, it may not provide an accurate idea about how well a particular fund may ultimately perform as the ratio is calculated based on historical data.
Many people, especially beginners, find mutual fund investments to be complicated. However, there is no reason to worry. A good way to start is to formulate investment objectives and preferred tenure and shortlist funds accordingly.
After that, the investor should evaluate certain parameters to assess the fund’s risks and potential for returns. The Sharpe ratio of mutual funds is an important criterion in this regard as it provides an idea about a fund’s risk-adjusted returns.
Frequently Asked Questions
Is 2.50 a good Sharpe ratio for a mutual fund?
Financial experts recommend investing in mutual funds that have a Sharpe ratio with a Sharpe ratio between 1.00 and 3.00. Such funds generate good returns while taking calculated risks.
When to use Sharpe and Treynor ratio?
Investors should use the Sharpe ratio when a fund’s portfolio lacks proper diversification. As this is a common occurrence, the Sharpe ratio is a popular metric among investors. On the other hand, the Treynor ratio is an ideal metric to use when the fund’s portfolio is well-diversified.
What is a mutual fund fact sheet?
A mutual fund fact sheet is a crucial source of information that investors need to consider before formulating their investment decisions. Some of the important components that this document contains are annualised returns of the fund, risk assessment and associated fees. In addition, the Sharpe ratio is one of the key ratios featured in a fund fact sheet.