William F Sharpe has propounded this ratio in the late 1960s. He was a Nobel laureate and a great professor of finance at Stanford University. Sharpe ratio is a widely used metric in the field of finance and economics. It helps investors in evaluating the relationship between risk and return of an asset. This tool provides an incremental understanding of the use of risk to earn a return by quantifying both the volatility and performance.
In the investment world, there are numerous factors that create conflict for investors with different risk & return combinations. In such varied scenarios, if anyone directly compares two investment avenues with different features, and different risk-profiles, without analysing their return expectation then, there is a higher chance of experiencing losses. Thus, the Sharpe Ratio is an accurate tool which is helpful for measuring the performance of the portfolio by analysing the risk and return perspective.
Sharpe ratio is a measure for risk-adjusted returns of the financial portfolios. Sharpe Ratio has adopted the example of apples and oranges for comparison in the investment world. Two instruments which are very different in features can be compared. So it takes into account the return in excess of a risk-free rate per unit of the volatility for each of these instruments. Since volatility is the proxy for risk in the investment perspective. We assumed that average investors belong to the risk-averse nature. Now you can compare apples to oranges within this ratio i.e. the higher the ratio, better will be the investment opportunities.
The objective of the Sharpe ratio is to measure the excess portfolio return over a risk-free rate related to its standard deviation. Normally, 90-day Treasury bill rate is considered as the proxy for a risk-free rate.
S: Sharpe Ratio
R p: Portfolio return
R f: Risk-free rate of return
Sigma (p): Standard deviation of the portfolio
Standard deviation is an extent of the volatility for a portfolio. A portfolio with a higher Sharpe ratio is considered superior relative to its peers.
It is very handy to measure a risk-adjusted return for the potential of a mutual fund. Generally, risk-adjusted return generates the returns earned over & above by the risk-free assets like fixed deposits or government bonds. The extra earned returns are considered as the “extra risk” to which an investor takes investing in risky assets like equity funds or stocks. The risk inherited in the investment is determined by the standard deviation.
Consequently, a higher Sharpe ratio indicates a better return of stock for the additional unit of risk bear by the investors. It would be helpful in justifying the underlying volatility of the stock. In fact, it is used for comparing the stocks.
Assuming that a stock would have the expected return is 8% and the risk-free rate of that stock is 2%. Then the standard deviation of the stock’s excess return is around 10%. What will be the Sharpe Ratio?
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Any two funds offer a similar return; one with a higher standard deviation will have the lower Sharpe ratio. To compensate for the higher standard deviation that the fund would require generating a higher return in order to maintain the higher ratio.
In a simple term, it represents how much additional return an investor will have to earn by bearing additional risk. Therefore, it can be inferred that a risk-free asset is zero for the Sharpe ratio.
Uses of Sharpe Ratio in Mutual Funds Selection
To Analyse Fund Strategy:
Sharpe Ratio is the powerful tools used for the selection of mutual funds. It is quantitative in nature and provides feedback on a fund’s performance. It analysed the degree of risk when two funds have earned extra returns at the risk-free rate. It is a standardized measure to compare the funds of different strategies like growth and value or a mix of both.
To optimize Risk-Return Trade-off:
It would desirable to be considering a fund with a high Sharpe Ratio because it took additional volatility. This means that when a fund achieves 7% of returns with a moderate level of volatility will always be considered better than a fund that gives 8% of returns with heavy fluctuations. A higher Sharpe ratio is the indication of the relationship between the risk and return of a fund which is ideal.
To Examine Portfolio Diversification:
Sharpe Ratio is used to identify whether the new or additional fund would be beneficial for your existing portfolio or not.
Suppose that the existing Sharpe ratio is 1.15 of your portfolio. The addition of one extra fund should increase this Sharpe ratio by decreasing the overall risk and increasing the returns. On the contrary, if this Sharpe Ratio lowers at 1.05, then this point indicates that you have to revise the diversification decision (adding that fund into an existing portfolio).
Drawbacks of Sharpe Ratio
There are several disadvantages with the application of Sharpe Ratio, because of certain assumptions and the ways it has been defined. The following important disadvantages are listed below:
- The assumption of Sharpe ratio pivots is that returns are normally distributed. In the actual market scenarios, the distribution might face the problem of kurtosis and fatter tails that reduces the relevance of its application.
- Sharpe ratio can’t differentiate between the intermittent and consecutive losses because risk measure is taken as an independent data point.
- Another notable drawback of this ratio is that it neglects the directions of the deviation and can’t distinguish between upside and downside. It only focuses on volatility
- Sharpe Ratio penalizes a system that exhibits sporadic sharp increased in the equity; even in the case of equity retracements were small.
- It is based on for historical returns and volatility and Sharpe ratio assumes that future performance will be the same as like past.
Sharpe ratio suggested that if any strategy is “statistically significant” and “statistically insignificant”, Sharpe ratio alone can’t be used to measure the strategy’s performance because of its drawbacks. Other performance evaluation ratios are helpful to overcome the limitations of Sharpe ratio. Like, Sortino Ratio is used only for a downside deviation of the volatility.