Sharpe ratio

Key Takeaways

  • Sharpe ratio measures the relative performance of funds or the performance of a portfolio manager.
  • Sharpe ratio is a measure of risk-adjusted return
  • Sharpe ratio is prone to be manipulated by choosing a better time period for calculation

What is the Sharpe ratio?

Sharpe ratio measures the relative performance of funds or the performance of a portfolio manager.

The Sharpe ratio can be calculated as the average returns in excess of the risk-free rate, divided by the standard deviation of returns, a measure of the average excess returns earned per unit of the standard deviation of returns. It is a commonly used method to find the risk adjusted return.

Another characteristic of the Sharpe ratio is that its value should generally increase with increasing diversification as compared to other similar portfolios with lesser diversification. The Sharpe ratio is also used to analyze the past performance of a portfolio.

Formula of Sharpe Ratio

The formula to calculate the Sharpe ratio is:

Sharpe ratio formula
Source: Tavaga

Where Sh refers to the Sharpe ratio, Rp refers to the returns on the portfolio, and Rf refers to the risk-free returns rate in the economy and Sp refers to the standard deviation of the returns of a portfolio. 

Significance of Sharpe Ratio

Importance of Sharpe ratio is given below:

It is a measure of risk adjusted return: Sharpe ratio throws light upon the returns that investment makes after all the risks are taken into account. It is desired for the Sharpe ratio to have a higher value as it suggests a better risk-adjusted performance.

It provides a comparison against the benchmark: Sharpe ratio gives an idea regarding whether one should invest in a particular fund as compared to similar funds in the same category.

It is also a way of comparing funds: It can also be used to compare funds in the same category. Two funds with similar returns but different risk levels can be analyzed using this ratio.

Limitations of Sharpe Ratio

Sharpe ratio makes use of return’s standard deviation in its denominator as a proxy of total risk of a portfolio. This assumes that returns on investment are normally distributed, but this is not always the case. In financial markets, the returns are skewed opposite of the average because there are generally a huge number of unexpected spikes and drops in prices.

Portfolio’s managers can also manipulate the Sharpe ratio to show their apparent history of risk-adjusted returns in good light. Increasing the measurement interval is a way to do this but the estimate of volatility gets lowered.

Another way to show better looking data is picking up a period for data with the better value of Sharpe ratio rather than choosing a neutral period.