Sharpe Ratio: Meaning, Advantages & Limitations

The Sharpe Ratio is the difference between the risk-free return and the return of an investment divided by the investment’s standard deviation.
In simple words, the Sharpe Ratio adjusts the performance for the excess risk taken by an investor. However, the investor can measure if the investment aligns his requirements with the Sharpe Ratio.
Sharpe Ratio is also used to carry out the performance of a particular share against the risk. It can compare two different funds that possess the same risk or same returns to help an investor understand how well he will be compensated.
Higher Sharpe Ratio means greater returns from an investment at a higher level. Thus, investors aiming to accumulate higher returns will invest in funds that come with higher risk factors.

The Sharpe Ratio of a mutual can be easily calculated by using a simple formula or by following these two steps mentioned below:
1. Subtract the risk-free return of a mutual fund from its portfolio return or the average return
2. Divide the subtracted number, which is called the excess returns, by the standard deviation of the fund’s returns.

Standard Deviation: Standard deviation showcases the investment return that varies from the principal returns of an investment.
A high standard deviation means there is a huge difference between the principal returns and the returns of an investment.
For example:
The annual Sharpe Ratio of a fund is 2.00. The more returns generated by the fund during the same time will be 2.00%.
Funds having a higher standard deviation makes higher returns as their Sharpe Ratio is considered high. However, funds with a low standard deviation can earn High Sharpe Ratio and give consistent moderate returns.
Sharpe Ratio can be calculated annually or on a monthly basis. Here’s the formula for the Sharpe Ratio:
Sharpe Ratio = (Average fund returns – Risk-free Rate) / Standard Deviation of fund returns

What is considered a Good Sharpe Ratio?

The above-given table shows the indicators of the good and bad Sharpe Ratio. Investments having less than 1.00 do not generate higher investor returns.
However, investments with Sharpe Ratio between 1.00 to 3.00 are considered great Sharpe Ratio and investments above 3.000 are considered excellent Sharpe Ratio.

Sharpe Ratio in mutual funds plays a significant role in generating returns and recognizing risk. It helps investors to identify the risk level and adjusted return rate of all mutual funds.
This gives a clear picture to the investors, and they get to know if the risk they take is giving good returns or not.
Let’s look at some advantages of the Sharpe Ratio:

• Analyze the fund’s performance

The Sharpe Ratio help’s investors to shed light on a fund’s performance. By looking at Sharpe Ratio, investors can carry out the level of risk of any fund in comparison with the extra returns.
It is majorly used to analyze mutual funds operations with both growth and value style.

• Helps In Fund Comparison

Beginners have the opportunity and can compare the Sharpe Ratios of various mutual funds to analyze their risk factors and adjusted-return rates.

• Investors Can Calculate the Risk Factor

With the Sharpe Ratio, investors can easily calculate all the risk factors before investing in mutual funds. In addition, existing investors can also decide to transfer their investment if their present fund gains a low Sharpe Ratio.

• Study The Portfolio Diversification

With the help of the Sharpe Ratio, investors can use it as a tool to identify the need for portfolio diversification.
Suppose, if an investor is invested in a fund with a Sharpe Ratio of 2.00, adding other funds to the portfolio would help reduce ratio and risk factors.
Additionally, it will increase returns. However, in the case of a fund with a Sharpe Ratio of 1.00, adding another fund to the portfolio may not be the ideal one.

• Examine The Risk and Return Rate

A fund having a higher Sharpe Ratio is considered great because it gives higher returns and higher risk. Therefore, investors looking to earn higher returns tend to opt for a fund that comes with a high ratio.
However, it can change the equation because a fund giving 5% returns with moderate volatility is always better than a fund having 7% returns with high volatility.

Despite having major advantages, the Sharpe Ratio also has few limitations mentioned below:
1) Sharpe Ratio of a fund does not take any responsibility for managing portfolio risks and does not reveal whether the fund is dealing with single or multiple factors.
2) It considers all the investments to have a normal pattern for the dispersion of returns, but funds may have different dispersion patterns.
3) The portfolio managers influence the Sharpe Ratio. They can try to boost their risk-adjusted free returns by lengthening the time horizon for measuring the ratio.
4) Sharpe Ratio is used to evaluate a mutual fund which is considered not a good strategy.

• What is the formula of Sharpe Ratio?

Sharpe Ratio = (Average fund returns – Risk-free Rate) / Standard Deviation of fund returns

• What is considered a good Sharpe Ratio?

However, investments with Sharpe Ratio between 1.00 to 3.00 are considered great Sharpe Ratio and investments above 3.000 are considered excellent Sharpe Ratio.

• How to measure the Sharpe Ratio?

There are two steps to measure the Sharpe Ratio?
1. Subtract the risk-free return of a mutual fund from its portfolio return or the average return
2. Divide the subtracted number, which is called the excess returns, by the standard deviation of the fund’s returns.

Final Thoughts

Several funds are operating in India, and selecting a mutual fund can be challenging, especially for newbies with less market knowledge.
These individuals can take the benefit of using the Sharpe Ratio to compare or evaluate the mutual funds. Thus, the Sharpe Ratio of mutual funds acts as an evaluation tool, but it can’t be the only single parameter.