The Sharpe Ratio is a widely used financial metric that measures the risk-adjusted return of an investment. It helps investors understand how much excess return they are receiving for the additional risk taken compared to a risk-free asset.
Table of Contents
The Sharpe ratio compares the return of an investment with its risk. It’s a mathematical expression of the insight that excess returns over a period of time may signify more volatility and risk, rather than investing skill.
Economist William F. Sharpe proposed the Sharpe ratio in 1966 as an outgrowth of his work on the capital asset pricing model (CAPM), calling it the reward-to-variability ratio. Sharpe won the Nobel Prize in economics for his work on CAPM in 1990.
Formula and Calculation
- Return of Portfolio: The average return generated by the investment.
- Risk-Free Rate: The return of a risk-free asset, such as U.S. Treasury bonds.
- Standard Deviation: Measures the volatility or risk associated with the portfolio’s returns.
Standard deviation is derived from the variability of returns for a series of time intervals adding up to the total performance sample under consideration.
What the Sharpe Ratio Can Tell You
The Sharpe Ratio evaluates returns relative to risk, allowing investors to compare investments. A higher Sharpe Ratio indicates a more favorable risk-adjusted return, meaning the investment provides better returns for the level of risk taken. For example, if two mutual funds have similar returns, the one with a higher Sharpe Ratio is more efficient at generating returns per unit of risk
By standardizing returns against risk, the Sharpe Ratio enables comparisons across asset classes, portfolios, or funds. For instance, you can use it to decide whether a high-risk stock portfolio or a balanced mutual fund suits your objectives better.
The Sharpe Ratio incorporates standard deviation (a measure of volatility) to assess performance. High volatility often implies high risk, but a high Sharpe Ratio indicates that this risk is being well-rewarded. Conversely, a low ratio warns of insufficient returns for the level of risk taken.
Investors use the Sharpe Ratio to adjust portfolios for optimal performance. For instance, you might increase holdings in assets with a higher Sharpe Ratio while reducing exposure to those with lower ratios.
In managed funds, the Sharpe Ratio reflects a manager’s ability to generate returns above the risk-free rate while managing risk. A consistently high Sharpe Ratio can indicate a skilled manager.
Sharpe Ratio Pitfalls
The Sharpe Ratio uses standard deviation as the sole measure of risk. However, standard deviation treats all volatility—positive or negative—as equal, even though investors might welcome upside volatility.
The choice of the risk-free rate significantly impacts the ratio. Inconsistent or outdated benchmarks can distort the metric.
The metric assumes that returns follow a normal distribution, which is often not true for real-world investments, especially in cases of asymmetric or fat-tailed distributions (e.g., hedge funds or derivatives).
Investments with significant tail risks (such as those exposed to extreme market events) may show a high Sharpe Ratio despite being inherently risky.
Example of How to Use the Sharpe Ratio
The Sharpe ratio is sometimes used in assessing how adding an investment might affect the risk-adjusted returns of the portfolio.
For example, an investor is considering adding a hedge fund allocation to a portfolio that has returned 24% over the last year. The current risk-free rate is 6%, and the annualized standard deviation of the portfolio’s monthly returns was 12%, which gives it a one-year Sharpe ratio of 1.5, or (24% – 6%) / 12%.
The investor believes that adding the hedge fund to the portfolio will lower the expected return to 18% for the coming year, but also expects the portfolio’s volatility to drop to 8% as a result. The risk-free rate is expected to remain the same over the coming year.
Using the same formula with the estimated future numbers, the investor finds the portfolio would have a projected Sharpe ratio of 1.75, or (20% – 6%)/ 8%.
In this case, while the hedge fund investment is expected to reduce the absolute return of the portfolio, based on its projected lower volatility it would improve the portfolio’s performance on a risk-adjusted basis.
If the new investment lowered the Sharpe ratio it would be assumed to be detrimental to risk-adjusted returns, based on forecasts. This example assumes that the Sharpe ratio based on the portfolio’s historical performance can be fairly compared to that using the investor’s return and volatility assumptions.
What Is a Good Sharpe Ratio?
Sharpe ratios above 1 are generally considered “good,” offering excess returns relative to volatility. However, investors often compare the Sharpe ratio of a portfolio or fund with those of its peers or market sector. So a portfolio with a Sharpe ratio of 1 might be found lacking if most rivals have ratios above 1.2, for example. A good Sharpe ratio in one context might be just a so-so one, or worse, in another.
Conclusion
By understanding the Sharpe Ratio, investors can make more informed decisions, balancing returns and risks effectively. It’s particularly valuable for those building diversified portfolios or comparing mutual funds and ETFs.
Must Read
7k