Sharpe ratio in mutual funds: Meaning, formula and limitations

Investing in mutual funds can be a simple way to potentially build wealth over time. However, when choosing where to invest your hard-earned money, it is important not just to consider the potential return on your investment but also the risk you may be taking. This is where the concept of Sharpe ratio in mutual funds comes in.

Sharpe ratio meaning is a risk-adjusted return metric that measure how much excess return an investment has generated relative to the risk per-unit taken in a given period. This article takes a closer look at what the Sharpe ratio is, why it is important, and how you can use to make well-informed investment decisions.

• Table of contents

1. What is Sharpe ratio?
2. Sharpe ratio formula
3. How does the Sharpe ratio work?
4. How to calculate Sharpe ratio
5. Importance of Sharpe ratio
6. What is considered a good Sharpe ratio?
7. What is the significance of Sharpe ratio?
8. Limitations of Sharpe ratio
9. Things to keep in mind while using the Sharpe Ratio

What is Sharpe ratio?

The Sharpe ratio is a financial metric developed by Nobel laureate William F. Sharpe. It tells you how much excess return an investment has generated in a given period for every unit of risk taken. The higher the Sharpe ratio, the better, because it means you’re getting more return potential for the level of risk you’re assuming.

Imagine you have two mutual funds to choose from. Both funds have earned a 10% return over the last year. However, if Fund A took on more risk to achieve that return than Fund B, the latter may be more suitable. The Sharpe ratio helps you see this by contextualising the returns of the funds based on the risk they took.

Sharpe ratio formula

The formula for calculating the Sharpe ratio is:

Sharpe Ratio = (Average Return − Risk-Free Rate) / Standard Deviation of Return

Here’s what each part of the sharpe ratio formula means:

• Average return: This is the return your mutual fund has generated over a specific period, like one year.
• Risk-free rate: This is the return you would get from a completely risk-free investment, such as a treasury bill. It's called “risk-free” because there is minimal chance of losing your invested capital.
• Standard deviation of return: This measures how much the return on your mutual fund has fluctuated over this period. It’s a way of quantifying the risk in terms of volatility of the fund’s performance.

The Sharpe ratio formula essentially tells you how much excess return (over the risk-free rate) the fund has generated in a given period for every unit of risk.

How does the Sharpe ratio work?

A higher Sharpe ratio signifies better risk-adjusted performance, indicating higher returns for the risk taken. A lower Sharpe ratio suggests that the returns may not sufficiently compensate for the associated risk.

Investors can use it to compare mutual funds, stocks, and other investments within the same category.

Investors can use the Sharpe ratio to assess mutual funds, stocks, and other financial products. It helps determine whether a fund manager’s performance is driven by skill or excessive risk-taking.

While debt funds generally carry lower risk than equity funds, they are not entirely risk-free. The Sharpe ratio helps compare their risk-adjusted returns.

The Sharpe ratio relies on historical data, which may not always reflect future market conditions. It assumes that returns follow a normal distribution, which may not always hold true. It should be used alongside other financial metrics for a more comprehensive investment evaluation.

How to calculate Sharpe ratio?

Here are the steps involved in calculating the Sharpe ratio:

1. Determine the average return: Start by finding out the average return of a mutual fund over a period, say five years.
2. Find the risk-free rate: Look up the current return rate for a government security or another low-risk investment over the same period as your mutual fund's return. This rate serves as your baseline.
3. Calculate the standard deviation: This step involves a little more computation, as you need to calculate how much the returns of the fund have fluctuated during this period. Some online platforms calculate this for you, or you can use a spreadsheet tool if you’re comfortable with numbers.
4. Apply the formula: Subtract the risk-free rate from the average return of your mutual fund. Then, divide that number by the standard deviation of the returns.

This is how you calculate the Sharpe ratio. If the result is a positive number, it means your fund has providing a return that’s higher than the risk-free rate, after adjusting for risk. The higher the number, the better the investment. You can also use this metric to calculate the performance of two funds in the same category to see which might offer a better risk-return balance.

While you can do this calculation manually, this information is also readily available online.

Importance of Sharpe ratio

Sharpe ratio is a useful metric for investors to make decisions aligned with their risk tolerance and their investment goals. Here are some of its benefits:

Risk-adjusted returns: It evaluates returns relative to the risk taken, offering a clearer perspective beyond just absolute gains.

Mutual fund evaluation: The Sharpe ratio helps compare mutual funds within the same category, such as large-cap or small-cap funds.

Informed decision-making: By analyzing an investment’s risk-reward profile, investors can align their choices with their financial goals and risk tolerance.

Performance benchmarking: It serves as a benchmark to track portfolio performance over time, ensuring consistency in risk-reward balance.

Managing volatility: In a volatile market like India’s, comparing Sharpe ratios helps identify investments that strike a better balance between risk and return.

Read also: How is Sharpe ratio calculated?

What is considered a good Sharpe ratio?

The answer to that question is fairly straight forward. Here’s how to differentiate between a good and a bad Sharpe ratio. Do note that the ratio considers past performance, which may or may not be sustained in the future.

• A Sharpe ratio above 1: This means that the mutual fund has provided more return than the risk it’s taking on. The higher the Sharpe ratio, the better the risk-adjusted return.
• A Sharpe ratio below 1: This indicates that the fund may not give you enough return for the level of risk you’re taking.

Keep in mind that it’s important to compare the Sharpe ratio of similar funds rather than using these numbers in isolation. Different types of funds (like equity vs. debt) can have different benchmarks for what’s considered a good Sharpe ratio.

What is the significance of Sharpe ratio?

Here are some reasons why the Sharpe ratio is an important metric for those who want to invest in mutual funds:

• Helps compare mutual funds: The Sharpe ratio allows you to compare the risk-adjusted return potential of different funds. Instead of looking at the returns alone, you can see which fund can potentially give you greater value after factoring in the risk.
• Informed decision-making: This metric helps you take more informed decisions on where to invest your money based on both the potential returns and the risk involved. This can help you choose funds that align with your investment goals and risk tolerance.
• Optimises your investment portfolio: By considering the Sharpe ratio, you can select a mix of funds that offer the highest return potential for a given level of risk. This can help you optimise your overall investment portfolio, ensuring a better balance between risk and reward.

Limitations of Sharpe ratio

While the Sharpe ratio is a useful tool, it has some limitations:

• Past performance is not a guarantee of future results: The ratio is based on historical data, meaning it reflects how a fund has performed in the past relative to the risk taken. This may or may not be sustained in the future.
• Ignores downside risk: The ratio treats all volatility as bad, but not all volatility is negative. It doesn’t differentiate between upside (positive) and downside (negative) volatility, which can misrepresent the true risk of an investment.
• Not useful for funds with low volatility: If a mutual fund has very low volatility (which means it doesn’t fluctuate much in value), the Sharpe ratio might not be very informative, as the risk-adjusted return potential could be inflated.
• Sensitive to the time period selected: The Sharpe ratio can change significantly depending on the time period over which it is calculated. Short-term performance may exaggerate the Sharpe ratio, while long-term performance might smooth out short-term volatility. It is thus advisable to look at Sharpe ratios over multiple cycles and longer horizons to get a more comprehensive view.

This is why it is important to also consider other risk-adjusted return metrics, such as Sharpe ratio, Treynor ratio, Sortino ratio, and Alpha for a more holistic view.

Things to keep in mind while using the Sharpe ratios

Here are some important considerations for investors when using Sharpe ratio for investment analysis:

Appropriate risk-free rate: Use a relevant benchmark, such as government securities or fixed deposit rates, and maintain consistency across comparisons.

Historical data limitations: The Sharpe ratio relies on past performance, which may not reflect future market conditions.

Standard deviation as a risk measure: The Sharpe ratio assumes a normal distribution of returns, which may not always apply in volatile markets.

Comparison within asset classes: The Sharpe ratio is relevant for comparing similar investments, such as mutual funds in the same category, rather than different asset classes.

Conclusion

Understanding what the Sharpe ratio is and how it works can help you make better investment decisions. By using this metric, you can compare different funds and choose the ones that match your risk tolerance and investment goals. However, bear in mind that this is just one of many tools available to an investor, and it’s important to consider other factors and metrics when evaluating mutual funds.

FAQs:

What does the Sharpe ratio mean in mutual funds?

The Sharpe ratio in mutual funds measures the return on an investment compared to the risk taken in a given period. A higher Sharpe ratio means a better risk-adjusted return potential, making it easier to choose funds that offer an optimum balance between risk and reward.

What is a good Sharpe ratio?

A Sharpe ratio above 1.0 is considered positive as it indicates that the investment has provided positive returns for the risk it has taken, during the period under consideration. The higher the ratio, the better it is.

Can the Sharpe ratio be less than 0?

Yes, the Sharpe ratio of a mutual fund can be less than 0. This usually happens when a mutual fund's returns are lower than the risk-free rate, implying that the fund is not performing well compared to a risk-free investment.

When should investors consider the Sharpe ratio?

Investors can use the Sharpe ratio when comparing different mutual funds to assess which ones offer better risk-adjusted return potential.

What does a Sharpe ratio of 0.5 mean?

A Sharpe ratio of 0.5 indicates that an investment has generated slightly excess return over the level of risk taken.

What if Sharpe ratio is high?

A high Sharpe ratio suggests that an investment has generated better returns relative to the risk taken. It indicates strong risk-adjusted performance, implying that the investment has delivered relatively higher returns for the level of volatility involved.

Is 7 a good Sharpe ratio?

A Sharpe ratio of 7 is extremely rare and not commonly observed in most investment scenarios. Generally, a Sharpe ratio above 1.0 is considered suitable. A ratio as high as 7 would imply exceptionally high returns for the risk taken, which is unlikely in most cases.

How to calculate Sharpe ratio?

The Sharpe ratio is determined by subtracting the risk-free rate from the investment's return and dividing the result by its standard deviation. The formula is: (Investment return - Risk-free rate) / Standard deviation.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.