While evaluating mutual funds, many investors often just look at historical returns and how schemes have fared against other mutual funds. However, this does not provide vital information about the market volatility that prevailed during the period of assessment. Here is where the Sharpe ratio can be of help. Formulated by Nobel laureate William F. Sharpe, this ratio considers the risk-adjusted returns of a financial portfolio and captures a fuller picture when comparing mutual funds for investment.
What is the Sharpe Ratio in Mutual Funds?
The excess return that a mutual fund generates when compared to an investment in a risk-free asset––such as a government securities––is called risk-adjusted returns. When this is measured relative to its standard deviation, it denotes the Sharpe ratio. It factors in the underlying volatility while evaluating a mutual fund to invest in. For example, a mutual fund with a higher Sharpe ratio indicates higher returns for the level of risk taken.
How to calculate the Sharpe ratio?
The Sharpe Ratio measures how much extra return an investment earns for the risk taken. It’s calculated by dividing the return above the risk-free rate by the investment’s volatility (standard deviation).
Given below is the mathematical formula for the calculation of the Sharpe ratio:
Sharpe ratio = (Return on investment – Risk-free return)/SD of investment return
Risk-free rate is usually taken from government securities (e.g., Indian 91-day T-Bills). Standard deviation measures the total risk/volatility of the portfolio over the same time period. The Sharpe Ratio may be computed on a monthly basis or annualised.
How to read the Sharpe ratio?
Ideally, the Sharpe ratio should not be read in isolation, as it is a relative measure. Investors can compare two or more funds to understand which fund offers better investment return potential compared to the risk taken, based on their respective Sharpe ratios.
By comparing the Sharpe ratios of different asset classes, such as stocks, bonds, and cash, investors can allocate their capital to achieve the desired balance of risk and return.
What is a good Sharpe ratio?
A higher Sharpe ratio denotes higher potential for returns considering the level of risk undertaken. Generally, a Sharpe ratio greater than 1 is considered acceptable, whereas a Sharpe ratio lesser than 1 generally doesn’t generate high returns relative to the risk taken. The following indicative table shows the range of Sharpe ratios and their respective reads, taking the risk rate into account.
|
Sharpe Ratio |
Risk Level |
Judgement |
|
Less than 1.00 |
Very Low |
Poor |
|
1.00 – 1.99 |
Moderate |
Good |
|
2.00 – 2.99 |
High |
Great |
|
3.00 and above |
Very High |
Excellent |
Importance of Sharpe Ratio
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Risk Assessment – Every investor tries to strike the right balance between risk and return when selecting the kind of asset to invest in. The Sharpe ratio aids in assessing a fund’s performance with respect to the risk-adjusted returns.
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Evaluating mutual fund performances – Since the Sharpe ratio is a relative financial measure, it is ideal for benchmarking mutual funds with other funds and making more favourable judgement calls.
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Benchmarking against the market – Investors can check whether a mutual fund has performed better or worse than the category and make better-informed decisions. For example, one can select a sectoral mutual fund and a sectoral index fund and compare the Sharpe ratios to analyse their performances and benchmark accordingly. A higher Sharpe ratio for the mutual fund would signify better potential for future risk-adjusted returns.
How to use the Sharpe ratio?
Let’s consider an example to understand how the Sharpe ratio can help an investor compare mutual funds based on returns for the level of risk undertaken.
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Fund X has an 18% average return with a standard deviation of 9%.
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Fund Y has an 18% average return with a standard deviation of 12%.
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Fund Z has a 26% average return with a standard deviation of 14%.
Considering a risk-free rate of 6%, the following are the Sharpe ratios for the funds:
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Fund X = (18% - 6%)/9% = 1.33
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Fund Y = (18% - 6%)/12% = 1.00
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Fund Z = (26% - 6%)/14% = 1.43
If we compare Fund X and Fund Y, both have generated the same returns. However, Fund X's Sharpe ratio is elevated due to its lower standard deviation of 9%, which indicates that lesser risk is incurred to achieve the same level of return.
If we compare Fund X and Fund Z, Fund Z has generated a 26% return but at a higher risk level, since the standard deviation is 14%. However, if we look at the Sharpe ratios of both the funds, Fund Z offers better risk-adjusted returns per unit of risk taken.
Limitations of Sharpe Ratio
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One of the key limiting factors of using the Sharpe ratio is its reliance on standard deviation alone to index a fund’s risk-adjusted returns. Since standard deviation measures both positive and negative fluctuations, even favourable movements can lead to a lower Sharpe ratio, which, in turn, can be falsely interpreted as a riskier fund.
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The Sharpe ratio does not reveal anything about diversification in a fund, since it does not capture portfolio risk.
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By considering a broader time frame or cherry-picking a particular time period, portfolio managers can influence the Sharpe ratio by a lowered estimate of market volatility. Hence, the Sharpe ratio should be used along with other financial metrics to analyse and compare funds.
Conclusion
Though relying on the Sharpe ratio alone is not recommended, it is an essential addition in an investor’s toolkit for analysing funds. It captures market volatility as well as serves as an important benchmarking instrument. Considering the ballooning number of funds to choose from in India’s current market, it can often become overwhelming for investors, and using the Sharpe ratio judiciously can be really useful.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.