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Named after its founder William F Sharpe, this ratio helps one to study the risk-adjusted performance of a mutual fund scheme. Technically, the ratio is defined as the excess returns of a scheme (over a risk-free rate) divided by the standard deviation of the scheme’s returns for a given period.
The risk-free rate can be 91 or 364-day Treasury-Bill issued by the government. The standard deviation is as a measure of risk; the higher the deviation, the higher the risk and hence, the lower the Sharpe Ratio. Simply put, this measure determines how the return of the scheme has compensated an investor for the risks he/she has taken. The higher the ratio, the better the compensation to the investor for bearing additional risk.
Let’s look at an illustration. Say Scheme Y returns 10% in a year while scheme Z returns 8%. If the risk free rate is 4%, and the standard deviation of Y and Z is 8% and 4%, respectively, then their respective Sharpe Ratios are 0.75 and 1. Thus, contrary to the initial inference that scheme Y was the superior performer (based on returns), scheme Z turns in a better performance on a riskadjusted basis.
However, you should note that this measure by itself provides little meaningful information. Using this measure makes sense when comparing schemes: The one with a higher Sharpe Ratio gives better returns for the same level of risk or the same returns with a lower level of risk. However, it is important to note that the schemes being compared should be of the same category. Comparing the Sharpe Ratio of a large-cap scheme with a sectoral scheme is fallacious as both funds are dissimilar.
As a rule of thumb, a Sharpe Ratio of 1 and above is good, 2 and above is very good and 3 and above is excellent.
It is advisable to look at this ratio over several periods to assess how the scheme(s) have fared in different market cycles.
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