What is a Sharpe Ratio in Mutual Funds?
Sharpe ratio helps measure the potential risk-adjusted returns from a mutual fund or any investment portfolio. Risk-adjusted returns are returns that an investment generates over and above the risk-free return.
It is used to understand the performance of an investment by adjusting for risk. The higher the ratio, the better the investment return with respect to the risk taken. You can use the Sharpe ratio to evaluate a stock, mutual fund portfolio, or investment.
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Sharpe ratio considers the inherent risk in an investment, i.e., the standard deviation. Therefore, the Sharpe ratio helps understand the return yielding capacity of a fund for every unit of risk it takes. Furthermore, you can use the Sharpe ratio to compare the performance of different funds.
The Sharpe ratio is calculated by dividing the average investment return minus the risk-free rate of return by the standard deviation of the investment’s returns.
Share Ratio = (Mutual Fund Returns – Risk Free Rate) / Standard Deviation
Importance of Sharpe Ratio in Mutual Funds
The Sharpe ratio is a measure of an investment’s return after taking into consideration all the inherent risks. Following is the importance of the Sharpe ratio in mutual funds:
- Measure Risk-Adjusted Returns: The Sharpe ratio helps in determining a fund’s performance against its inherent risk. A higher Sharpe ratio for a mutual fund portfolio implies the better its risk-adjusted return. On the other hand, a negative Sharpe ratio indicates that it is better to invest in a risk-free asset than a fund with a negative ratio.
- Comparing Funds: Sharpe ratio is a popular metric for comparing funds that belong to the same category. For instance, comparing the performance of large-cap mutual funds. Comparing funds belonging to the same category will ensure that both funds are exposed to the same level of risk. On the other hand, you can also compare funds with similar returns but at different risk levels.
- Comparing a Mutual Fund with its Benchmark: In addition to comparing mutual funds in the same category, you can also use the Sharpe ratio to compare the fund to its benchmark. Such a comparison helps you identify if the fund is underperforming or outperforming the benchmark. As a result, you can understand how well the fund is performing for the risk that it is undertaking.
How To Calculate Sharpe Ratio in Mutual Funds?
To calculate the Sharpe ratio, subtract the risk-free rate of return from the expected return from a mutual fund. Then divide that difference by the mutual fund portfolio’s standard deviation. At the end of the year, you can use the Sharpe ratio to look at the actual return rather than the predicted return.
It’s a metric for calculating the extra return on each additional unit of risk incurred. It is calculated monthly and then annualised for ease of understanding in most cases.
Furthermore, the Sharpe ratio is easily found in the fact sheet of a mutual fund.
Let’s understand the Sharpe ratio calculation with the help of an example.
|Mutual Fund||Expected Return||Risk-Free Rate||Standard Deviation||Sharpe Ratio|
From the above table, looking at the expected return, Fund A seems to perform better and generate higher returns for investors.
However, when considering the risk factor and computing the Sharpe ratio, Fund B has a higher value. This means Fund B is able to generate higher returns on a risk-adjusted basis. Since the Sharpe ratio for Fund B is higher than Fund A, Fund B is a better investment option.
Furthermore, a Sharpe ratio of 1.20 means for every 1% increase in yearly volatility, the fund delivers an additional 1.20% return. A fund with a larger standard deviation should achieve higher returns to maintain a higher Sharpe ratio. A fund with a lower standard deviation, on the other hand, can obtain a higher Sharpe ratio by continuously achieving moderate returns.
Interpretation of Sharpe Ratio
Sharpe ratio is a useful metric that you can use for selecting an investment. You can interpret the following using the Sharpe ratio:
- Analyse a Mutual Fund’s Investment Strategy: Sharpe ratio is a popular metric for mutual fund evaluation. This quantitative metric provides an overview of a fund’s performance. It helps in comparing the performance of two funds. You can analyse the risk taken by the fund to generate returns higher than the risk-free rate. It’s a standardised tool for comparing funds with different strategies, such as value, growth, etc.
- Portfolio Diversification: You can use the Sharpe ratio to determine if you should add another mutual fund to your existing investment portfolio. Let’s assume your investment portfolio has a Sharpe ratio of 1.20. Adding a new fund to it should help you reduce the risk and increase portfolio returns. If the Sharpe ratio is falling, it is wise to reconsider the fund choice and diversification decision.
- Risk Return Trade off: Fund A might generate 15% return and is highly volatile, but Fund B might generate only 12% returns with moderate to low volatility. Though Fund B offers a lesser return, it is a better investment option. Ideally, funds that offer consistent returns with moderate to low volatility are preferred. A higher Sharpe ratio indicates that the risk-return relationship of the fund is optimum.