What is Sharpe Ratio in Mutual Fund and What is Its Significance?
What is Sharpe Ratio?
The Sharpe Ratio is a measure of a risk-adjusted return on a financial portfolio. It helps in establishing the underlying volatility of the mutual funds while representing its anticipated risk-adjusted returns. A risk-adjusted return is a measure of an investment’s return or potential earnings that considers the degree of risk that must be incurred to achieve it.
This blog helps understand what Sharpe Ratio in mutual funds is, its formula, importance and how it is used to calculate risk-adjusted returns. Keep reading!
Did you Know
Sharpe ratio is named after American economist William F Sharpe, a Nobel laureate and a retired professor at the Stanford University
Mutual funds with a higher Sharpe ratio are better adjusted against the risks to generate returns against their counterparts. On the other hand, mutual funds with a lower Sharpe ratio rank lower in terms of risk-adjusted returns in comparison to their peers.
How Does Sharpe Ratio Work?
Investors use the Sharpe Ratio in mutual funds to understand and assess the performance of their investments. It is an important calculation for determining the returns on an investment in relation to the risk or its risk-adjusted returns. Modern portfolio theory says that adding assets to a diversified portfolio that has low correlations can generate returns without losing any profits.
Sharpe Ratio Interpretations
- A Sharpe ratio of less than 1.0 is considered poor
- A Sharpe ratio of 1.0 is regarded as adequate or good
- A Sharpe ratio of 2.0 or higher is considered very good
- A Sharpe ratio of 3.0 or higher is regarded as excellent
- A Sharpe ratio of 0 indicates that there are no returns over the risk-free rate
A stock with a high Sharpe Ratio has higher returns in comparison to the amount of investment risk. A negative Sharpe Ratio indicates that the risk-free rate is higher than the expected return on the stock. A risk-free asset has a Sharpe Ratio of zero. If the assets in a diverse portfolio have a low to negative correlation, it may lower total portfolio risk while increasing the Sharpe Ratio.
Why is Sharpe Ratio Important?
The Sharpe Ratio plays an important role in mutual funds. With the help of Sharpe Ratio, investors can determine whether the risk is worth taking against the result generated by the mutual fund. Let’s look at some key benefits of Sharpe Ratio:
- Helps calculate risk-adjusted returns
- Aids in fund comparison: comparison of this ratio of investment options can be used to compare the risk factors and adjusted-return rates
- Aids in benchmark comparison: Investors can comprehend the performance of their assets by comparing their existing or preferred fund to peer funds.
- Analyse the fund’s performance: Investors can analyse the level of risk in contrast to the extra rewards
- Portfolio diversification: Investors can use the ratio to determine whether they need to diversify their portfolio.
- Examine the risk and return rate: A fund with a higher Sharpe Ratio is thought to have a better return, but it also carries a higher risk.
Sharpe Ratio Formula
The formula of Sharpe Ratio is:
1. Sharpe Ratio = (Rp – Rf) / Standard deviation
- Rp – Portfolio return
- Rf – Risk-free rate
- Standard deviation – It is a risk assessment based on volatility. The lower the standard deviation, the lower the risk and vice versa.
The (Rp – Rf) element of the formula represents the market risk premium. It is the excess return over the risk-free rate.
The ratio should provide a clear picture of the risk-reward connection, demonstrating how much extra return is gained for the higher risk.
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Sharpe Ratio Calculation – How to Calculate Sharpe Ratio?
A simple method can be used to compute the Sharpe ratio of any mutual fund by following two steps:
1. Sharpe ratio formula: Sharpe Ratio = (Rp – Rf) / Standard deviation
- First subtract the mutual fund’s risk-free return from its portfolio return on average return.
- Then divide the subtracted number by the standard deviation of the fund’s return to calculate the excess returns.
The standard deviation determines how much difference there is between an investment’s return and its principal return. A large standard deviation shows a large difference between an investment’s returns and its principal returns. Funds with high standard deviation receive better returns, resulting in a high Sharpe Ratio. However, funds with a low standard deviation can also result in a higher Sharpe Ratio if they consistently give back good returns. Sharpe Ratio can be computed monthly or annually.
Sharpe Ratio Example
An investor is thinking about adding a new mutual fund to their current portfolio. It is currently split between equities and bonds and has returned 12% in the last year. The current risk-free rate is 3%, and the standard deviation is 12%, resulting Sharpe Ratio = 0.9%, or (12% – 3%)/12%
The investor wants to add the new fund into his portfolio to reduce its predicted return to 10% for the coming year but to also reduce the standard deviation to 7%. The investor believes that the risk-free rate will remain unchanged in the following year. Using the same calculation and the projected future values, the investor discovers that the portfolio has an expected Sharpe Ratio = 1%, = (10% – 3%) /7%.
This example of Sharpe Ratio shows us that the addition of the new fund investment reduces the portfolio’s return, but it also reduces the portfolio’s volatility and improves its risk-adjusted performance. This example implies that the Sharpe Ratio may be fairly compared to projected future performance based on historical performance.
How is the Sharpe Ratio Used to Calculate Risk-adjusted Return?
You can calculate risk-adjusted return using Sharpe Ratio by following the steps mentioned below:
- Subtract the risk-free rate from the return of an investment.
- Divide that by the asset’s standard deviation of return.
The Sharpe Ratio isolates an asset’s typical earnings independent of risk. The Sharpe Ratio in mutual funds computes an investment’s excess returns over the risk-free rate per unit of volatility using standard deviation, a statistical measure of variation.
Advantages of Sharpe Ratio
Sharpe Ratio provides the following advantages to investors:
- The most advantageous thing about Sharpe Ratio is its simple formula. You need not require a strong financial background in Maths or Statistics. It is dependent on the investment’s own number.
- It provides a comparison between investment types. The Sharpe Ratio has the advantage, especially when compared to other risk measures, of being applicable to all types of assets.
- Helps in choosing the investment that suits the investor’s requirements.
Limitations of Sharpe Ratio
Despite the advantages and significance, Sharpe Ratio does have some limitations:
- Sharpe Ratio is based on standard deviation, which depends on the normal distribution curve
- Sharpe Ratio does not differentiate between volatility and treats all volatility the same way.
- Comparing the ratio of two or more funds only gives an idea about risk-adjusted returns.
Sharpe Ratio vs Sortino Ratio
The Sharpe Ratio and Sortino Ratio are both metrics used to evaluate investment performance, but they differ in how they measure risk. The Sharpe Ratio considers both the return and volatility of an investment, while the Sortino Ratio only looks at downside volatility, or the volatility of returns that fall below a certain threshold. As a result, the Sortino Ratio may provide a more accurate assessment of risk for investments with a higher frequency of downside volatility. However, the Sharpe Ratio remains a widely used and useful tool for evaluating risk-adjusted returns.
Treynor Ratio vs Sharpe Ratio
The Sharpe Ratio and Treynor Ratio are both performance metrics used in finance. While the Sharpe Ratio measures risk-adjusted returns by taking into account the total volatility of an investment, the Treynor Ratio looks specifically at the systematic risk of an investment relative to the market. Essentially, the Treynor Ratio measures how much excess return an investment generates for each unit of market risk it takes on.
Final Word
The Sharpe Ratio is a useful tool for analysing your assets. It considers both your earnings and your risk, and it shows you whether your returns are worth the level of risk you are willing to face. It is a popular metric among investors for assessing investment success. The ease of calculating and analysing the ratio contributes to its popularity.
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Disclaimer: Mutual fund investments are subject to market risks, read all offer documents carefully
FAQs
The Sharpe Ratio in mutual funds is a performance measure that evaluates a fund’s risk-adjusted returns by considering both the total return and the volatility of the fund’s investments over a certain period of time.
Typically, a Sharpe Ratio of 1 and above is considered adequate or good.
A Sharpe Ratio greater than 1 is considered good, greater than 2 very good and greater than 3 is excellent.
A negative Sharpe ratio, typically below 1, indicates that an investment’s return was less than the risk-free rate, meaning the investment did not adequately compensate for the risk taken.
A zero Sharpe ratio indicates that an investment’s return is equal to its risk-free rate, meaning there is no excess return generated beyond what is expected from the risk taken.
Warren Buffett’s Sharpe ratio is a metric used to evaluate the risk-adjusted return of Berkshire Hathaway’s portfolio. It is calculated by dividing the portfolio’s excess return over the risk-free rate by its standard deviation.
Yes, a Sharpe ratio can be less than 0, indicating that the investment’s return is lower than the risk-free rate or that its volatility is very high.
A Sharpe ratio of 0.5 indicates that the investment’s return is generating 0.5 units of excess return for each unit of risk taken, relative to the risk-free rate. This could be considered an average sharpe ratio.
A Sharpe ratio of 1.5 indicates that the investment is generating 1.5 units of excess return for each unit of risk taken, relative to the risk-free rate. It implies better risk-adjusted performance than a lower Sharpe ratio.
A Sharpe ratio of 0.7 would be considered average at best, as a ratio of 1 and above is considered good.
Yes, Sharpe Ratio can be used to compare assets. It is also frequently employed by institutional investors that manage big portfolios for multiple investors to optimise returns while minimising risk.
The Sharpe Ratio is used to help investors evaluate an investment’s return in relation to its risk. The average return earned more than the risk-free rate per unit of volatility or total risk is the ratio.
Sharpe Ratio is frequently used by investors to make asset allocation decisions and compare portfolios.
The greater a fund’s Sharpe Ratio, the better its returns have been in comparison to the risk it has taken on. It helps compare risk-adjusted returns across fund categories because it employs standard deviation.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
