Understanding the Sharpe Ratio, an Investors Friend

As the analytical tools available to the small-time investor become more advanced it is important to take a step back and not forget the importance of traditional performance metrics.

One such metric is the “Sharpe Ratio” developed by Nobel laureate William Sharpe. In simple terms, the Sharpe Ratio enables us to measure risk-adjusted performance of an investment; recording if positive performance is due to skilled management or excessive exposure to risk. This is achieved calculating for the past 36 month period by dividing a funds annualized excess returns over the risk-free rate (this risk free rate is usually derived from Treasury Bill rates – government issued fixed-interest securities which owing to their US government backing are seen to be risk free), by its annualized standard deviation. (Standard deviation [std dev/SD], is a quantity expressing by how much the members of a group differ from the mean value for the group, i.e. the dispersion of the values above and below the mean).

Using the Sharpe Ratio we are able to compare, for example, two funds side-by-side and determine which fund best manages risk to produce returns. A higher return does not necessarily mean “better managed” and the Sharpe Ratio illustrates which investments better compensate investors for their exposure to risk. A high Sharpe Ratio dictates good risk-adjusted performance. A negative Sharpe Ratio would indicate that your money would have performed better in a risk-free asset (T-Bills or equivalent).

This metric enables us to look beyond measuring the performance of funds on a pure-return basis and manage risk more effectively in-line with our personal preferences. We can also compare the Sharpe Ratios of different portfolios, or peer group for more in-depth comparative analysis across different asset classes, sectors or indices. As a rough rule of thumb, a reading of 1 is good and 2 is remarkable. After comparing the values across different securities you will soon get a feel for what is to be expected.

By way of an example, take a look at the 3 following mutual funds that would undoubtedly get the nod from William: