How to interpret the Sharpe Ratio for evaluating Mutual Funds…

One of the more scientific methods of evaluating your mutual fund performance is the Sharpe Ratio. Designed by William Sharpe, this method measures your returns on the fund per unit of risk. Why is this measure so important? You need to remember that mutual fund returns, by themselves, only provide a part of the picture. Let us understand this point in much greater detail…

Why return per unit of risk…

If equity mutual fund “A” has earned 14% per annum and equity mutual “B” of a similar risk and portfolio profile has earned 17% per annum, then which is the better performing mutual fund? Prima facie, it appears that the fund generating 17% returns is the better performing fund. But there is one more aspect to consider; and that is the aspect of risk taken by the fund manager. Let us assume that the fund manager of “B” has invested predominantly in mid cap stocks and rate sensitive stocks betting that the RBI will cut rates in its monetary review. In doing so, the fund manager has indirectly exposed his investors to a higher degree of risk. For example, if the US Fed had hiked rates, then the RBI would have been compelled to also hike rates in India to make Indian debt competitive. In this scenario the investors in Fund “B” would have suffered as they are exposed to rate sensitive stocks. This risk is not captured when you consider pure returns on the fund. The answer to this problem could be the Sharpe Ratio.

Understanding the Sharpe Ratio…

The Sharpe ratio has two parts to it. Firstly, in the numerator it captures the excess returns over the risk-free returns. This is important because when you are assuming higher risk on equity, you need to earn more than what you would earn on a government bond or a bank FD. Secondly, this excess return so calculated is divided by the Standard Deviation (SD). The SD captures the volatility in the stock and is therefore the closest proxy to risk of the stock. It follows that higher the standard deviation, higher the risk. Dividing the excess returns by the standard deviation gives us the Sharpe Ratio. It therefore follows that the Sharpe ratio can improve if the fund returns go up, the risk free rate goes down or the SD reduces.

Mathematically, the Sharpe ratio can be expressed as under:

(Returns on the Fund – Risk Free Return) / Standard Deviation of Returns

So if the fund has earned 15% and the risk free rate is 9% and the standard deviation is 3, then the Sharpe ratio will be:

(15% – 9%) / 3: Therefore the Sharpe ratio will be 2.

Comparing funds on the Sharpe ratio gives us an apple to apple comparison

How to use Sharpe ratio in practice…

The big question is how can investors interpret and practically use Sharpe ratio. Remember, Sharpe ratio in isolation does not mean anything, but when it is compared across funds it can give some useful insights. Today, most of the funds disclose the Sharpe ratio of the fund in their monthly fact sheets which is available on the websites of the mutual fund. You can also go to websites like Morningstar and Value Research and compare Sharpe Ratios across funds to get a better perspective.

When comparing among similar funds, a higher Sharpe ratio is more preferable. It means that the fund is generating a higher level of returns with a lower level of risk. It specifically is a statement on the strategy adopted by your fund manager. If a fund earns a high return but has a lower Sharpe ratio, it means that your fund manager is earning higher returns by taking on higher risk. That is equivalent to putting your capital at risk. That is not what you expect when you put your money in a diversified equity mutual fund. Your aim is to leverage on the professional fund management skills and the benefit of diversification to create wealth in the long term. That is why the Sharpe ratio can give you useful insights as a mutual fund investor.

As a mutual fund investor one needs to get used to these simple analytical metrics. Remember, the Sharpe ratio in isolation does not convey too much, but as a comparative tool, it can give useful insights. The general focus is on the returns of the fund. Sharpe ratio enables you to capture the inherent risk in your fund investment. For long term wealth creation, managing your risk and keeping it within acceptable limits is absolutely essential.

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