What is the Sharpe Ratio?

The Sharpe ratio is a financial metric that helps investors to measure the relationship between the risk level and return on an investment. Named after the Laureate William F Sharpe, it mathematically showcases that making higher returns might not always be due to a high investment skill, but increased volatility and risk also have their roles.

From its calculation, a higher ratio typically indicates a potentially more efficient investment. In India, about 5.20 crore are invested in mutual funds, and investors in stocks and other assets are also rising.

With the increasing investment trend and to ensure a potential risk-adjusted return on investment, learn about this ratio here.

How Does the Sharpe Ratio Work?

A Sharpe ratio in investment typically works on the evaluation of how efficiently your investment converts associated risks into returns. It shows whether the potential return on investment you gain is justified by the existing volatility or not.

This idea of this ratio aligns with your aim as an investor, i.e. enhancing your return potential while taking on the least possible risks. By calculating Sharpe ratio, you get a score that helps you estimate your risk-adjusted return on your investment, especially in mutual funds.

Therefore, from this calculation, a higher ratio typically means potentially greater returns but with higher risk. Suppose you locate a stock with a potential 14% annualised ROI, with sharp price swings, and a Sharpe ratio of 1.1. It shows that its return might potentially outweigh the price swings or volatility.

On the other hand, a mutual fund with a 10% annualised return and with a moderate volatility might have this ratio at 1.3. Despite a lower raw return, this higher score might be effective in ensuring a better risk-adjusted return than the stock investment.

Thus, by understanding what is Sharpe ratio and its respective score against an investment asset are, you as an investor can choose an option that matches your risk profile. It is typically effective to ensure that you are rewarded for the risks you are willing to take.

Applicable Formula to Calculate the Sharpe Ratio

To get an understanding of your risk-adjusted return on your investment, you must learn the formula for calculating Sharpe ratio. It considers an average ROI, a risk-free rate and the respective standard deviation of a fund. Here is a detailed view of it:

Sharpe ratio = (Average returns on investments – Risk-free rate) / Standard Deviation of the return

Here, the average return on investment means the return an investment asset has generated over a specific period in the past.

The risk-free rate here means returns that potentially risk-free investment instruments have generated. These investment instruments typically include government and corporate bonds, bank fixed deposits, treasury bills, etc.

A standard deviation on an investment asset essentially means how much it can deviate from its expected return. Suppose a fund has a standard deviation of 5% and its average return is 12%. It might generate either 7% or a 17% return.

Thus, by placing the respective information in this formula, you can get a Sharpe ratio of an investment tool and estimate its potential risk-adjusted return. Typically, this ratio ranges from below 1 and might go up to more than 3, representing a poor or an efficient investment choice.

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Calculation of the Sharpe Ratio of an Investment

Now that you have noted the applicable formula to calculate the Sharpe ratio, you must have a clear idea of how this formula estimates your risk-adjusted return. For this, take a look at the following examples:

As investors generally consider a Sharpe ratio before investing in a mutual fund, let us consider two different mutual funds:

Suppose you locate a mutual fund with an average annualised return of 25%. Its risk-free rate and its respective standard deviation are at 5%.

Now, let us place this information into the above formula:

Sharpe Ratio = (Average returns on investments – Risk-free rate) / Standard Deviation of the return

Sharpe Ratio = (25 – 5) / 5 = 4.

On the other hand, imagine you have located another fund with the same annualised return as the previous one. Its risk-free return is at 5%. However, it has a higher standard deviation of 10%.

Thus, its prevailing Sharpe ratio using its formula results in:

Sharpe ratio = (25-5) / 10 = 2.

From the above examples or comparison between two fund options, you can arrive at the following potential outcomes:

Due to the higher Sharpe ratio, the first mutual fund under discussion has the potential to perform better than the second one.

The higher ratio also indicates a potentially better risk-adjusted return. Based on the calculation, the first option might provide a more attractive risk-adjusted return.

Also, as the prevailing Standard Deviation (SD) is higher for the second fund, it represents a higher volatility in its underlying asset. Thus, it makes the fund a potentially riskier avenue to invest in.

What is considered a good Sharpe Ratio?

Upon understanding how to calculate Sharpe ratio, it is imperative to have an insight into which ratio is typically considered efficient or poor by investors. As you already know, the Sharpe ratio ranges from below 1 to beyond 3, you grade them in the following manner:

Thus, from the above table, you might want to consider an investment with a Sharpe ratio between 2 and 3 or beyond. Also, you should avoid an investment with a ratio below 1, as its return might not be sufficient to cover the risk involved.

Advantages of Using the Sharpe Ratio

Before you invest based on the Sharpe ratio, you must have a look at its detailed advantages so that you can utilise this tool to ensure a potential risk-adjusted return more efficiently:

1. Acts as a Risk-Adjusted Return Calculator

Suppose you are looking for a mutual fund to invest in. With this ratio, you can estimate the risk factor associated with it before investing in it. If you are already invested in a mutual fund, you might choose to transfer your existing fund to a new one if the ratio of the new fund is better.

2. Assist With Comparison Between Funds

If you are a beginner investor and are opting for mutual funds, you might not have a broader idea to assess the risk profile of funds using different metrics or factors. As the Sharpe ratio clearly shows a poor or an efficient investment choice through numerical ranges, it becomes easier to choose a fund with a potential for risk-adjusted return.

3. Helps With Portfolio Diversification

This ratio might be helpful to ensure diversification. For example, if you have invested in assets like a mutual fund or any other instrument with a Sharpe ratio of 2 or beyond, adding another fund or an asset might be a good choice here. However, if the current ratio of your investment is 1 or below, adding further funds might not be a wise decision.

4. Assess the Rate of Risk and Return

As you have seen, an investment with a higher return typically comes with a higher risk and might have a higher Sharpe ratio. However, the respective volatility might impact this equation. For example, a fund investment option with a 12% return with moderate volatility is always better than a fund with a  15% return but with a higher volatility.

Limitations of Using the Sharpe Ratio

Aside from noting its advantages, you must also remain aware of its key disadvantages to make informed investment decisions:

1. Lack of Context

While the Sharpe ratio considers average return, risk-free rate and standard deviation to arrive at a score, it disregards a few key arrears. It typically does not consider the portfolio risk of the fund or asset under consideration. Also, it does not show whether the fund is invested in a single or multiple sectors, narrowing the visibility of the asset.

2. Assumption of Normal Distribution

This ratio also considers that all investments have a normal dispersion in terms of returns. However, in reality, funds or investment options might have different dispersion patterns of return, reducing their reliability. As a result, it might underestimate the actual risk in investments that experience sudden spikes, crashes, or irregular return patterns.

3. Limited in Revealing True Risks

It allows you to compare the Sharpe ratios of two investment options, and based on which you choose one. However, two different options might have an equal ratio or negligible differences, which makes them equally strong. What might happen here is that one might carry risks, such as liquidity issues, sector concentration, etc, that this ratio cannot reveal, increasing your overall risks if you invest in that one.

Conclusion

The Sharpe ratio acts as an indicator for investment instruments to reveal their potential to provide an optimised risk-adjusted return. Especially used for mutual funds, investors consider their readings to compare funds with a benchmark, with other funds and invest.

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FAQ’s on Sharpe Ratio

1. What if the Sharpe ratio is high?

Investors consider a higher Sharpe ratio of an investment instrument to be better for an optimised risk-adjusted return. For example, in mutual funds, a Sharpe ratio of 3 or beyond is typically an excellent investment choice.

2. Can a Sharpe ratio be negative?

Yes, in investments, a negative Sharpe ratio is possible. Suppose you see a negative ratio against an instrument. It typically indicates that it generated lower returns than its risk-free rate per unit.

3. How to analyse the Sharpe ratio?

Analysing the Sharpe ratio is easy. All you need to do is use its formula. First, you must deduct the risk-free rate from an investment’s average return and then divide the outcome by its standard deviation.

4. What is a zero Sharpe ratio?

A zero Sharpe ratio means an investment has generated a return exactly the same as the return of a risk-free asset. It indicates that this investment has not generated any additional return against the taken risk.