Information, when not put in the right perspective, can be misleading at times. The returns churned up by a fund or a portfolio, for example. It is generally assumed that high returns mean better performance. While this may be true in some cases, the real picture of a portfolio's performance can be gauged when the returns it generates are assessed with respect to the risk it assumes.
This is where the Sharpe Ratio comes in handy. The downside risk of investing is one aspect that needs to be given due importance. High returns are generally associated with a high degree of volatility, which is not always the case. Hence, to get the right analysis of a portfolio, its returns must be viewed in tune with its risk factor. The Sharpe Ratio assesses the returns generated by a portfolio against per unit of risk undertaken.
Mathematically, the Sharpe Ratio is the difference between the portfolio's returns over and above the return earned on a risk free investment divided by the standard deviation of the portfolio. The standard deviation is the risk factor of the portfolio. Standard deviation is used as it is indicative of the volatility in the fund. A lower standard deviation implies little fluctuation in the returns. And when the Sharpe Ratio is thus calculated, the higher it is the better. A higher Sharpe Ratio represents a higher return generated per unit of risk.
However, while looking at Sharpe Ratio, one has to keep in mind that in isolation it has no meaning. It can only be used as a comparative tool.
Thus the Sharpe Ratio should be used to compare the performance of a number of portfolios or funds. In case of mutual funds, one can compare the Sharpe ratio of a fund with that of its benchmark index. If the only information available is that the Sharpe ratio of a fund is 1.2, no meaningful inference can be drawn as nothing is known about the peer group performance. Another aspect to look out for is that the ratio can be misleading at times. For example, a low standard deviation can unduly influence results. A fund with low returns but with a relatively mild standard deviation can end up with a high Sharpe ratio. Such a fund will have a very tranquil portfolio and not generate high returns.
Hence, in conclusion, a Sharpe Ratio will invariably tell you which of the portfolios under comparison is performing to the best of its abilities.
You can easily find the Sharpe Ratio of a fund on VRO. There are two ways.
1. You can visit a fund page and go the Performance tab. Under it, you will find a category called Risk Measures. 2. You can use the Fund Selector tool (as shown below) and go to Risk Stats tab to find the Sharpe Ratio of different funds.
This story originally appeared in May 2008.