All About Sharpe Ratio

The Sharpe ratio theory was developed by William F Sharpe. The Sharpe ratio helps in accessing if an investment is giving good returns for the risk you are taking. It measures the risk-adjusted return of an investment.

What is Sharpe Ratio?

The Sharpe ratio is a key metric used to evaluate how much return an investment generates relative to the level of risk it carries. Essentially, a higher Sharpe ratio indicates better risk-adjusted performance.

Formula and Calculation of the Sharpe Ratio

To calculate the Sharpe ratio, you need to use the following formula:

Sharpe ratio = (Return of the portfolio - Risk Free Return) / Standard Deviation. 

                                            = (R(p) - R(f)) / SD

  • Here, (R(p)) represents the historic return of the fund. These returns can be for any period. However, it is always better to take a long-term period.
  • (R(f)) represents the risk-free return, which could be taken from instruments like government bonds or fixed deposits offered by banks. 
  • Standard deviation (SD) reveals the degree of volatility/risk associated.

What Does the Sharpe Ratio Tell You?

The Sharpe ratio is a widely used metric for assessing risk-adjusted returns of an investment, such as a mutual fund. It reflects how much excess return an investment generates per unit of risk, where risk is measured by the standard deviation of returns.

When contrasted with industry sector returns or investing strategies, the Sharpe ratio offers insights into risk-adjusted performance independent of such affiliations. This ratio aids in determining whether historical returns were accompanied by excessive volatility. While excess returns are compared against an investing benchmark, the Standard deviation formula evaluates volatility based on return variants from their mean.

A higher Sharpe Ratio indicates that the fund has delivered better returns for the amount of risk taken, suggesting superior risk-adjusted performance. Conversely, a low or negative Sharpe Ratio implies that the return may not justify the risk or may be lower than the risk-free rate.

What is Considered A Good Sharpe Ratio?

When it comes to determining what constitutes a good Sharpe ratio, higher is generally better.  A ratio of about one is considered favorable, indicating a higher return for each unit of risk taken.

Example of How to Use the Sharpe Ratio

Let's delve into how the Sharpe ratio is out in the real-world scenario with some relatable examples. Consider four distance investment funds:

  • Fund A: Historical return of 15% for a standard deviation of 8%.
  • Fund B: Historical return of 15% for a standard deviation of 10%.
  • Fund C: Historical return of 20% for a standard deviation of 12%.
  • Fund D: Historical return of 10% for a standard deviation of 6%.

Now, let’s calculate the Sharpe ratio for each fund using the Sharpe ratio formula:

Funds

Returns (%)

Standard Deviation (%)

Risk-Free Rate (%)

Sharpe Ratio

A

15

8

6

1.125

B

15

10

6

0.9

C

20

12

6

1.17

D

10

6

6

0.67

According to the above table, fund B has the same returns as fund A. Despite this, its higher standard deviation results in a lower Sharpe ratio. Similarly, fund C offers higher returns than fund A. However, due to its increased standard deviation, the Sharpe ratio remains at par. This demonstrates how the Sharpe ratio offers a precise perspective on risk-adjusted returns. It guides investors towards making informed decisions.

Alternatives to Sharpe: The Sortino and the Treynor

When it comes to investment metrics, the Sharpe ratio is not the only metric. Here are two notable alternatives:

  • Sortino Ratio: Unlike the Sharpe ratio, the Sortino ratio zooms in on downside risk. It focuses on below-average returns, offering a more focused assessment of a portfolio’s risk. With this, investors can gain insights in order to manage potential losses effectively.
  • Treynor Ratio: Designed to evaluate systematic risk exposure, the Treynor ratio compares excess return to the volatility of the broader market. By considering the benchmark by the beta, it provides a distinct understanding of how a security or portfolio performs relative to market movements. 

Why is Sharpe Ratio Important?

The Sharpe ratio plays a crucial role in mutual funds by helping their risk-adjusted performance. Here are the reasons why the Sharpe ratio in mutual funds is beneficial: 

  • Risk Assessment: It provides insights into the mutual fund scheme’s risk level. A higher Sharpe ratio indicates a better risk-adjusted return, implying greater risk for potentially higher returns.
  • Comparison with Benchmark: It helps investors understand whether the scheme has outperformed or underperformed. For instance, if you are considering investing in an Equity Fund, comparing its Sharpe ratio to its benchmark Nifty 50 index can provide valuable insights. It would help the investor understand how this scheme would fare in the broader market. This comparison aids in evaluating the fund’s performance relative to its benchmark.
  • Fund Comparison: Comparing different mutual funds within the same category becomes easier because of the Sharpe ratio. By analysing which fund offers a higher risk adjusted returns, investors can align their choices with their risk tolerance and financial objectives.
  • Portfolio Diversification: By showcasing the scheme’s risk level, investors can determine if diversification is necessary. If a fund has a high Sharpe ratio, adding another scheme to the portfolio can help mitigate the overall portfolio risk. 

Limitations of the Sharpe Ratio

Despite its advantages, the Sharpe ratio has its fair share of limitations: 

  • Portfolio Risk Responsibility: The Sharpe ratio does not show where the risk is coming from and only measures the risk-adjusted returns. It leaves investors unaware of the portfolio’s risk distribution.
  • Comparison of Risk-Adjusted Returns: Comparing the Sharpe Ratios of different funds provides insights into their risk-adjusted returns but does not account for other influencing factors such as market conditions, liquidity, or management style.

Conclusion

Navigating different mutual funds available in India can pose a challenge, particularly for newcomers or those less versed in market intricacies. Tools like the Sharpe ratio help compare how different mutual funds perform for the risk they undertake to assess and compare mutual funds. With Sharpe ratios readily accessible online for various mutual funds in India, investors gain a quantitative measure to make an informed decision. However, while the Sharpe ratio serves as a useful evaluation tool, it should not stand alone. Investors should do a comprehensive analysis of mutual funds beyond this metric to develop a well-informed investment strategy. It is advisable to consult a tax advisor before making any investment decisions. 

Mutual Fund investments are subject to market risks, read all scheme related documents carefully

Please note that this article or document 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 or document 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 in any manner. 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 or document.

Published on Jun 09, 2025

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