Sharpe Ratio: Definition, Formula, Calculation and Limitations

Generally, a mutual fund’s performance is judged based on its historical returns. However, past years’ returns of a scheme tell only half of the story and are not entirely indicative of the future returns. It is important to know the risk profile of various mutual fund’s schemes and then invest accordingly. One of the quantifiable variables used to assess the returns delivered by a fund for each unit of risk taken, is Sharpe Ratio.

What is Sharpe Ratio?

Sharpe Ratio gives an overview of the risk-adjusted performance of a mutual fund scheme. Risk-adjusted returns refer to the returns generated above the returns delivered by a risk-free asset.

This ratio tells investors how better the fund has performed when compared to the performance of risk-free instruments such as government bonds or bank fixed deposits.

Sharpe Ratio Formula & Calculation

• Sharpe Ratio is calculated by dividing the difference between the portfolio returns and rate of return of a risk-free instrument with the standard deviation of the fund returns. The nominator gives us the value of excess returns, which basically means how much more has the fund delivered compared to risk-free financial instrument
• The denominator is the standard deviation of mutual fund returns which tells us about how much has the fund returns deviated from the average returns
• If the value of the Sharpe Ratio is 1.5, it essentially means that the fund has delivered 1.5% more returns than that from a risk-free financial asset
• A negative Sharpe Ratio means that an investment in a risk-free instrument is more profitable than in that specific mutual fund scheme

Use of Sharpe Ratio in selecting Mutual Funds

• Sharpe Ratio is one of the crucial parameters that helps investors pick the best mutual scheme. It gives a quantitative perspective about a fund’s performance
• One can compare the risk exposure of two or more funds by analysing their Sharpe Ratio. It gives an objective outlook of the degree of risk a mutual fund took while delivering excess returns than the risk-free rate
• A fund with high Sharpe Ratio might have delivered high returns, but there is a high probability that the fund manager took a lot of risk while formulating the investment portfolio. So, a fund with low Sharpe Ratio delivering slightly low returns is more preferable than a fund with high sharpe ratio delivering high returns as the latter has high volatility
• Sharpe ratio also helps in identifying whether an investor needs to diversify the existing portfolio by adding a new mutual fund scheme. If the addition of new scheme increases the Sharpe Ratio of the overall investment portfolio, then one can consider adding it to the portfolio, as it will increase the overall return of the portfolio

Limitations of Sharpe Ratio

• Sharpe Ratio alone as a quantitative tool to judge mutual fund’s performance is not so useful. It should be compared to other funds from the same category for efficient comparison and analysis
• Sharpe Ratio doesn’t give any information about the portfolio risk, whether the equity investment is skewed towards a particular sector or not. If it is, then the risk on investment is quite high, which the sharpe ratio of the fund might not reflect
• The formula for Sharpe Ratio uses the standard deviation of mutual fund returns in the denominator to arrive at its value. The basic assumption here is that returns are normally distributed
• However, mutual fund returns in reality greatly vary from the average returns of the category, and may hover towards the extremes. This may influence the value of the Ratio, which may not show the true picture of risk-adjusted performance of the fund
• One can also manipulate a fund’s sharpe ratio by extending the measurement interval. This results in a dip in fund’s volatility. The standard deviation of daily returns will be higher than that of monthly or yearly returns. So, fund managers can put the value of standard deviation for annual returns, instead of monthly returns, to increase the magnitude of Sharpe Ratio

Also Check: How to Calculate Information Ratio

Frequently Asked Questions

Q.1: What does a negative Sharpe ratio mean?

Ans: Sharpe Ratio shows negative results when the investment returns are lower than the risk-free rate. However, a negative sharpe ratio does not completely denote anything. There can be two cases, either the risk-free rate is greater than the portfolio returns or the portfolio returns are expected to be negative. The higher the sharpe ratio, the better is the risk-adjusted performance.

Q.2: What is the difference between the Sharpe ratio and the information ratio?

Ans: Information Ratio is a tool used to measure the performance of an investment as compared to its benchmark with risk-adjusted returns over a period of time. On the other hand, Sharpe Ratio helps to measure the risk-adjusted returns of a mutual fund scheme. 

Q.3: What is a good information ratio for a mutual fund?

Ans: 0.4 to 0.6 is a good information ratio for any mutual fund. And, if it is greater than 0.61 to 1.00, it is considered as a great investment option.