If you are an investor who wants to compare different mutual funds based on their risk and return, you may find the Sharpe ratio useful. The Sharpe ratio is a measure of how much excess return a fund generates per unit of risk taken. It helps you evaluate the performance of a fund by adjusting for risk.
The Sharpe ratio is calculated by subtracting the risk-free rate of return from the fund’s return and dividing it by the fund’s standard deviation. The risk-free rate of return is the return that you can earn from a safe investment, such as a treasury bill or a fixed deposit. The standard deviation is a measure of how much the fund’s return fluctuates over time. A higher standard deviation means more volatility or risk.
The formula for Sharpe ratio is:
Sharpe ratio = (Fund return – Risk-free rate) / Standard deviation
For example, suppose you have two mutual funds, A and B, with the following characteristics:
Fund A: Return = 20%, Risk-free rate = 6%, Standard deviation = 10%
Fund B: Return = 15%, Risk-free rate = 6%, Standard deviation = 8%
The Sharpe ratio for Fund A is:
Sharpe ratio = (20% – 6%) / 10% = 1.4
The Sharpe ratio for Fund B is:
Sharpe ratio = (15% – 6%) / 8% = 1.125
Based on the Sharpe ratio, Fund A has a higher risk-adjusted return than Fund B. This means that Fund A delivers more return for the same amount of risk or less risk for the same amount of return.
However, the Sharpe ratio should not be used in isolation to compare mutual funds. It is a relative measure that depends on the choice of the risk-free rate and the time period of calculation. It also does not capture other aspects of risk, such as downside risk or market risk. Therefore, you should also look at other factors, such as the fund’s objective, strategy, portfolio composition, expense ratio, and past performance before making an investment decision.