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Sharpe Ratio in Mutual Fund - Calculation & Formula

If we were to tell you that a mutual fund scheme gave 12% annualised returns (hypothetically), you might be tempted to invest in it for want of high growth of your invested money. This factor, the return garnered from the scheme, though a valid one, must not be the only factor behind deciding your investment. You must consider the risk too. Every investment has a degree of risk associated with it. In fact, it is often a higher risk that has the potential to produce a high return. But is the risk in your investment worth the returns? Or, in other words, how much return are you getting for every unit of risk that you undertake? One of the ways to assess this factor i.e. the return per unit of risk undertaken is called the Sharpe Ratio.

Understanding Sharpe Ratio (SR)

Now, this extra risk is calculated with respect to the risk associated with that mutual fund scheme. For the calculation of Sharpe Ratio, this risk is determined and represented by the standard deviation. Standard deviation (SD) attempts to calculate the extent to which a scheme’s returns may fluctuate and compares that with the historical return of the scheme. For example, if a scheme has an SD of 7% and a historical return of 12% (hypothetically speaking), then the scheme’s return could possibly range from 5% to 21%.

With this information, let us now derive at the calculation of Sharpe Ratio-

Sharpe Ratio Formula - Nippon India Mutual Fund

As an example, let us calculate the Sharpe Ratio of a scheme with an average return of 12%. Assuming the risk-free return to be 5% and the SD to be 5%, the Sharpe Ratio becomes (12%-5%)/5%= 1.4. Thus, for every unit of risk undertaken, this scheme produces an extra 1.4% return every year. Obviously, a higher SR may be in your favour as it represents higher returns per unit of risk taken. But what if the SR is higher because the scheme has a lower SD and not because the returns are actually better? Hence, SR should always be looked at, in conjunction with SD. For example, a scheme with a higher SD may have to maintain higher returns to maintain a high SR, and similarly, the one with a lower SD can do so with moderate returns as well.

Now, the standalone figure of 1.4 may not mean anything to you when trying to gauge performance. For it to make sense, you will always need to compare the Sharpe Ratios of similar mutual fund schemes and understand which one is giving you a possibility of better returns with an optimal risk.

In Summary-

Measure Sharpe Ratio - Nippon India Mutual Fund

Things to keep in mind-

  1. Always use SR as a comparison tool and use it to compare mutual fund schemes of the same category and similar investment objectives.
  2. You will find different values of SR for the same mutual fund scheme from different sources. When comparing, choose one reliable source and get your data from that source only.
  3. Look at the SR in tandem with the SD, and not alone.
  4. You can check the SR against the benchmark performance, to see whether it is underperforming or overperforming against the benchmark.
  5. It does not give you an idea about the kind of portfolio that works.

When choosing mutual fund schemes, SR can help you make a better choice. You can get in touch with your Mutual Fund Distributor if you do not understand any aspect of the comparisons of SRs for different schemes.

ABOVE ILLUSTRATIONS ARE ONLY FOR UNDERSTANDING, IT IS NOT DIRECTLY OR INDIRECTLY RELATED TO THE PERFORMANCE OF ANY SCHEME OF NIPPON INDIA MUTUAL FUND. THE VIEWS EXPRESSED HEREIN CONSTITUTE ONLY THE OPINIONS AND DO NOT CONSTITUTE ANY GUIDELINES OR RECOMMENDATION ON ANY COURSE OF ACTION TO BE FOLLOWED BY THE READER. THIS INFORMATION IS MEANT FOR GENERAL READING PURPOSES ONLY AND IS NOT MEANT TO SERVE AS A PROFESSIONAL GUIDE FOR THE READERS.


Disclaimer:
Helpful information for investors: All Mutual Fund investors have to go through a one-time KYC (know your Customer) process. Investors should deal only with registered mutual funds, to be verified on SEBI website under 'Intermediaries/ Market Infrastructure Institutions'. For redressal of your complaints, you may please visit www.scores.gov.in . For more info on KYC, change in various details & redressal of complaints, visit mf.nipponindiaim.com/investoreducation/what-to-know-when-investing This is an investor education and awareness initiative by Nippon India Mutual Fund.

The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their associates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document. Language Disclaimer:
While utmost care has been taken in translating the article into respective regional language(s), in case of any confusion or difference of opinion, article available in English language should be deemed as final. The article provided herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional advice for the readers. The document has been prepared on the basis of publicly available data/ information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their associates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of loss of profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this article. "ABOVE ILLUSTRATIONS ARE ONLY FOR UNDERSTANDING, IT IS NOT DIRECTLY OR INDIRECTLY RELATED TO THE PERFORMANCE OF ANY SCHEME OF NIMF. THE VIEWS EXPRESSED HEREIN CONSTITUTE ONLY THE OPINIONS AND DO NOT CONSTITUTE ANY GUIDELINES OR RECOMMENDATION ON ANY COURSE OF ACTION TO BE FOLLOWED BY THE READER. THIS INFORMATION IS MEANT FOR GENERAL READING PURPOSES ONLY AND IS NOT MEANT TO SERVE AS A PROFESSIONAL GUIDE FOR THE READERS."

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