De-Jargoned | Sharpe Ratio

De-Jargoned | Sharpe Ratio

What is it?

Investment performance is usually measured by both return and risk—both can’t and shouldn’t be seen in isolation. Sharpe ratio is a simple way of examining the excess return (or risk premium) you make when you take risk or volatility (standard deviation) in the portfolio. This excess is the return a portfolio earns over and above the risk-free rate of return. Sharpe ratio measures whether the risk taken is worth the extra return generated compared with a similar portfolio.

How is it calculated?

To calculate the ratio we need three components—portfolio return, risk-free rate of return and the standard deviation—all for a defined period of time.

Portfolio return [R(p)]is simply the change in value of a portfolio measured for the defined time period. Standard Deviation of returns [Sd(p)]measures the variation from average return. A low standard deviation indicates that returns during a period tend to be close to the average or stable and a high standard deviation indicates that the returns are more spread out or volatile. Risk-free rate of return [R(f)] is the return earned on an investment with minimum or close to zero risk. Return earned on benchmark government securities are often considered as a proxy for this.

The formula to calculate Sharpe ratio: [R(p) - R(f)]/Sd(p).

When is it used?

Also known as the reward-to-variability ratio, Sharpe ratio is used to compare the performance of two or more portfolios or mutual fund schemes. Wealth managers and financial planners find it useful while comparing the performance of different products with market-linked returns. As an individual investor, you can use it to compare performance across mutual fund schemes, particularly funds where the portfolio risk is high, such as equity funds, risk-oriented debt funds and commodity funds.

Watch out for

Just by itself, the Sharpe ratio figure doesn’t mean much—you’ve got to compare it with the Sharpe ratio of another fund to ascertain its risk-adjusted return.

Also, this ratio considers both upside and downside volatility. In simple words, if your fund’s net asset value (NAV) goes up from, say, 30 to 40, this spike will be punished by Sharpe ratio. In reality, though, any upside volatility is welcome because you end up making money, it’s only when your NAV drops that you actually lose money. Sharpe ratio fails to recognize this difference.