Explained: Sharpe Ratio: A Key Metric for Risk-Adjusted Returns

Sharpe ratio It is one of the most crucial tools for evaluating the performance of mutual fundsThis indicator was developed by Nobel laureate William F. Sharpe and measures the risk-adjusted performance of an investment, helping investors determine whether a mutual fund’s returns are sufficient given the level of risk assumed.

The Sharpe ratio of a mutual fund reveals its potential risk-adjusted returns. Risk-adjusted returns are the returns earned on an investment compared to the returns generated by any risk-free asset such as a fixed deposit. However, higher returns indicate additional risk.

What is the Sharpe ratio?

The Sharpe ratio is a mathematical formula used to evaluate how much additional return an investment provides for each unit of risk assumed. It is calculated as follows:

Sharpe Ratio = Excess Return (Average Return – Risk-Free Return) / Standard deviation of return of fund

• Fund Performance: Refers to the total returns generated by the mutual fund.
• Risk-free rate: Usually represented by government bond yields, the risk-free rate is the return on an investment without the risk of financial loss.
• Standard deviation of returns: Measures the volatility or risk of the mutual fund’s returns. A higher standard deviation means that the fund’s returns fluctuate more, indicating higher risk.

Read also | Nifty hits record highs: 5 things investors should do now

How does the Sharpe ratio help?

The main purpose of the Sharpe ratio is to give investors a clear idea of ​​whether a fund’s returns are justified in light of the risk involved. For example:

• A higher Sharpe ratio indicates better risk-adjusted returns, meaning the fund is efficiently generating returns for the amount of risk it is taking.
• A lower Sharpe ratio indicates a low risk-adjusted return, suggesting that the fund may not be adequately compensating for the risk involved.

Interpretation in mutual funds

1. Positive Sharpe Ratio: A positive Sharpe ratio means that the fund’s performance has exceeded the risk-free rate, which is a favorable indicator for investors. The higher the positive value, the better the fund has performed relative to its risk.
2. Negative Sharpe Ratio: A negative Sharpe ratio suggests that the fund’s return is lower than the risk-free rate, which may indicate poor performance. In this case, investors may want to reconsider their investment in the fund.

Read also | This large-cap fund turns Rs 10,000 monthly SIP into Rs 1.33 crore in 20 years

Example: Consider two mutual funds:

• Fund A has an annual return of 12%, a risk-free rate of 6% and a standard deviation of 8%.
• Fund B has a return of 14%, a risk-free rate of 6% and a standard deviation of 10%.

For Fund A:

Sharpe index = (12−6) / 8 = 0.75

For Fund B:

Sharpe index = (14−6) 10 = 0.80

While Fund B has a higher return, its higher volatility (or risk) makes its Sharpe ratio only slightly better than that of Fund A. This comparison shows that the Sharpe ratio helps investors make more informed decisions by taking risk into account.

Limitations of the Sharpe ratio

• It only measures past performance: The Sharpe ratio uses historical data, so it cannot always predict future performance.
• It assumes symmetric risk: it assumes that investment risks are normally distributed, but some investments may have asymmetric risk profiles.

The Sharpe ratio is a valuable tool for investors looking to evaluate mutual funds based on risk-adjusted returns. It allows for better comparisons between funds, particularly when choosing between high-yield but high-risk options versus more stable funds. However, it is important to use it in conjunction with other metrics and take into account the broader market context of the fund.