Definition of Sharpe Ratio
Sharpe Ratio is a ratio that is used to calculate the stability of the return of a particular mutual fund to risk free assets like Fixed Deposit or Government Bonds
This ratio is commonly used to compare the return stability of two mutual funds in the same asset class that have similar rates of return.
For example, sharpe ratio of 1.35 means that particular mutual fund will yield 1.35% returns extra than fixed deposit, considering the volatility of the stock market in that year was 1%.
Note that volatility is also considered as standard deviation in many cases, they both mean the same.
What relevance does sharpe ratio hold
Imagine a scenario, where you want to invest some money. Now you have selected 2 assets: Mutual fund and Fixed Deposit. It is understood that mutual funds yield a higher rate of return compared to fixed deposit.
On the other hand, fixed deposits give a uniform rate of return irrespective of the market conditions. The returns shown today by a mutual fund may not be same tomorrow. Hence the saying goes, “Mutual funds are subject to market risk”.
Thus, sharpe ratio will analyze as to by how the particular mutual fund is performing by also considering the risk (volatility) factor and not just the rate of return.
How to use sharpe ratio
Understanding the mathematical point of view
The formula for Sharpe Ratio is given by the following mathematical statement:
Sharpe Ratio = ( Returns of mutual fund – Returns of Fixed Deposit ) / Standard deviation
- Returns of a mutual fund is the probable returns it has given in the previous year
- Returns of fixed deposit / or any asset that has zero risk (even Government Bonds can be considered in may cases)
- Standard Deviation / Volatility of that particular fund.
Understanding sharpe ratio with an example
Consider a mutual fund with a NAV (Net Asset value) of Rs. 100 per unit and has given a return of 12% in the previous year. The NAV of the mutual fund had touched a low of Rs. 85 and a high of Rs. 125. The returns of Fixed Deposit in that particular year were 5%.
Now to determine the standard deviation (volatility) we have,
SD = (High – low) / NAV value X 100
= (125 – 85)/100 X 100 = 40%
A standard deviation of 40% tells us that this mutual fund is a very high risk mutual fund. The standard of a fairly performing mutual fund should be less than 10% in the worst case.
Sharp Ratio = (Returns of mutual fund – Returns of Fixed Deposit) / Standard Deviation
= (12 – 5) / 40 = 0.175
The sharpe ratio of this particular mutual fund = 0.175.
This information tells us that the mutual fund will only yield 0.175% more than the Fixed Deposit at 1% volatility. Hence, we can come to the conclusion that investing in a fixed deposit is a better alternative than investing in this particular mutual fund.
It is surprising to see that a fixed deposit that yields 5% is a better investment than a mutual fund that has yielded 12% in the previous year.
Sharpe Ratio also takes the volatility of that asset class into account and not only the rate of return. Hence, this is a better way to gauge the performance of a mutual fund.
Sharpe ratio and volatility
Since the sharpe ratio is inversely proportional to standard deviation (volatility), it will tell us that a high sharpe ratio value will be achieved when the volatility of that mutual fund is low. A less volatility means the fund is less risky and vice versa.
Thus, a mutual fund with low sharpe ratio can also mean that that the fund has a high risk of investment. This needs to be balanced with higher rate of return.
A mutual fund with a higher sharpe ratio is always preferred for stable returns and low market risk.
When comparing between two mutual funds having the same rate of return, the one with a higher sharpe ratio will always be preferred.
Positive vs negative Sharpe Ratio
Sharpe ratio of a mutual fund should always be positive. This indicates that the fund will give better returns than fixed deposits. For the high risk an investor takes for choosing to invest in mutual fund should be rewarded with better rate of return.
When a mutual fund has a negative sharpe ratio it simply means that an asset class like Fixed Deposit will give a better return than investing in that mutual fund. A negative sharpe ratio is an indication that investing in a Fixed Deposit is a better choice.
A mutual fund with a sharpe ratio less than 1 should also be avoided as the risk one takes to invest should not be rewarded with low rates of return. One needs to find mutual funds having sharpe ratio of more than 1%
It is to be noted that sharpe ratio is not the only form of ratio that will determine the overall performance of the mutual fund. An investor must use it as only one of the tool to compare the difference between mutual funds and mutual funds and fixed deposits.
Also one needs to understand that when investing in small cap mutual funds that are extreme in high risk are bound to have a low sharpe ratio as they will be very volatile to the market. That does not mean that small cap mutual funds are bad. They will tend to give better return over a long duration.