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-
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
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.
Things to keep in mind-
- Always use SR as a comparison tool and use it to compare mutual fund schemes of the same category and similar investment objectives.
- 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.
- Look at the SR in tandem with the SD, and not alone.
- You can check the SR against the benchmark performance, to see whether it is underperforming or overperforming against the benchmark.
- 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.