What is Sharpe Ratio?

Introduction

Many times you will hear investing professionals talk about risk-adjusted returns. This is what the Sharpe Ratio is - a measure of performance or return on a portfolio. The performance of any portfolio has two components, risk and return. In order to ascertain the total efficacy of the portfolio, it is necessary to measure both the return and the risk. A measure of an investment's return relative to its risk, the Sharpe ratio.

What Is the Sharpe Ratio?

As a by-product of his work on the capital asset pricing model (CAPM), economist William F. Sharpe presented the Sharpe ratio in 1966 under the name reward-to-variability ratio. Sharpe's work on the CAPM earned him the 1990 Nobel Prize in Economics.

The Sharpe ratio, is a metric for evaluating an investment's performance that accounts for risk. A single security or a whole investment portfolio can be assessed using it. In either scenario, the investment is better in terms of risk-adjusted returns the greater the ratio.

One can assess investments based on expected profits. But when you realise how much risk you've taken on with a single stock or your entire portfolio to earn those profits, you gain a deeper knowledge of an investment. This is the meaning of adjusted returns for risk.

The Sharpe ratio allows investors to compare an investment's return to the additional risk it carries, above and beyond the return on a risk-free asset. This comparison helps investors determine if higher returns are sufficiently rewarding for taking on more risk.

Usually, investors have two competing objectives. First and foremost, they always aim to maximise their investment returns. Second, they seek to reduce risk, which is another term for wanting the least amount of likelihood that they will experience a financial loss.

The difference over time between realised, or expected, returns and a benchmark—such as the risk-free rate of return or the performance of a specific investment category—is the numerator of the Sharpe ratio. The standard deviation of returns over the same time period, a gauge of risk and volatility, serves as its denominator.

Investors receive a score from the Sharpe Ratio that indicates their risk-adjusted returns. In either scenario, this important financial ratio aids the investor in determining if gains are the result of wise choices or just taking on excessive risk. It may be utilised to assess historical performance as well as anticipated future performance. If the latter, when market conditions shift, investors can lose more than they can bear.

The Sharpe ratio is a popular risk-adjusted relative return measure. It compares a fund's historical or forecasted returns to an investment benchmark and their variability.

The method first employed the risk-free rate to represent an investor's hypothetical minimum borrowing expenses. More generally, it represents the investment risk premium over a Treasury bill or bond.

In contrast to industrial sector or investing strategy returns, the Sharpe ratio measures risk-adjusted performance without such affiliations.

The ratio helps determine how much past returns were accompanied by volatility. Based on return variance from their mean, the standard deviation formula measures volatility, whereas excess returns are calculated against an investing benchmark.

The ratio assumes that historical relative risk-adjusted returns are predictive.

The Sharpe ratio measures risk-adjusted portfolio performance. An investor could also determine a fund's Sharpe ratio ex-ante using its return objective.

The Sharpe ratio can show if a portfolio's excess returns are due to savvy investing or luck and risk.

Portfolio risk-adjusted performance improves with higher Sharpe ratios. A negative Sharpe ratio suggests the risk-free or benchmark rate is higher than the portfolio's historical or predicted return, or the portfolio's return is expected to be negative.

How to Calculate the Sharpe Ratio

To calculate the Sharpe Ratio, the following formula is used: Sharpe Ratio = (Rp – Rf) / Standard deviation. This has the following meaning:

• Rp - the expected return on the asset or the portfolio being measured.
• Rf - the risk-free rate.
• Standard deviation is a measure of risk based on volatility. The lower the standard deviation, the less risk and the higher the Sharpe ratio, all else being equal, or vice-versa.

How to Use Sharpe Ratio

The Sharpe ratio is employed to evaluate the potential impact of a new investment on the portfolio's risk-adjusted returns. An investor might be thinking about increasing the allocation to hedge funds in a portfolio that has gained 18% in the past year. Given the current risk-free rate of 3% and the monthly returns of the portfolio's annualised standard deviation of 12%, the portfolio has a one-year Sharpe ratio of 1.25, or (18 - 3) / 12.

The investor anticipates that by include the hedge fund in the portfolio, the projected return for the upcoming year will be reduced to 15%, but the volatility of the portfolio will also decrease to 8%. Over the upcoming year, it is anticipated that the risk-free rate will not change.

The investor determines that the portfolio would have a projected Sharpe ratio of 1.5, or (15%) - (3%) divided by 8%, using the same formula with the expected future values.

In this instance, the hedge fund investment is anticipated to lower the portfolio's absolute return, but because of its anticipated decreased volatility, it would enhance the portfolio's performance when taking risk into account.

Forecasts would indicate that the additional investment would be harmful to risk-adjusted returns if it decreased the Sharpe ratio. The underlying premise of this example is that the Sharpe ratio derived from the past performance of the portfolio may be comparably with that derived from the investor's return and volatility expectations.

Drawbacks of the Sharpe Ratio

Portfolio managers can alter the Sharpe ratio in an attempt to improve their historical apparent risk-adjusted performance. One way to achieve this is by extending the return measurement intervals, which will lead to a reduced volatility estimate. For instance, annual returns often have a lower standard deviation (volatility) than monthly returns, which are comparatively less volatile than daily returns. When utilising the Sharpe ratio, financial analysts usually take monthly return volatility into account.

Another technique to cherry-pick data that will distort risk-adjusted returns is to calculate the Sharpe ratio for the most favourable stretch of performance rather than an impartially selected look-back period.

There are some inherent restrictions to the Sharpe ratio as well. As a stand-in for portfolio risk, the standard deviation computation in the denominator of the ratio computes volatility using a normal distribution and is most helpful when assessing symmetrical probability distribution curves. On the other hand, herding-prone financial markets have a far higher propensity to reach extremes than would be predicted from a normal distribution. Consequently, tail risk may be underestimated by the standard deviation used to compute the Sharpe ratio.

Serial correlation also affects market returns. The simplest example is that returns from neighbouring time periods that were impacted by the same market trend could be connected. However, mean reversion, like market momentum, is also dependent on serial correlation. In summary, investing strategies that rely on serial correlation variables may show deceptively high Sharpe ratios since serial correlation tends to reduce volatility.

The investment technique of picking up nickels in front of a steamroller, which moves slowly and predictably almost all the time, save for the few, rare instances when it abruptly and catastrophically accelerates, can help visualise these arguments. Those that pick up nickels would often give positive returns with little volatility and strong Sharpe ratios because such tragic events are extremely rare.

Furthermore, even if a fund that was doing well in the long run ended up getting crushed by a steamroller on one of those incredibly rare and terrible instances, its long-term Sharpe might still seem decent because it was only one bad month. Unfortunately, investors in the fund would not be much comforted by it.

It's critical to remember that the Sharpe ratio makes the assumption that the average returns on an investment are distributed properly over a curve. A normal distribution has fewer returns in the curve's tails and a majority of returns that are symmetrically clustered around the mean.

An unexplained variation in the Sharpe ratio might occur when the standard deviation is not sufficient to adequately reflect the estimated risk.

Regretfully, normal distributions are a poor representation of the actual financial markets. Investment returns do not follow a normal distribution in the near run. Although the distribution of returns on a curve clusters near the tails, market volatility might be greater or lower. As a result, standard deviation may become less reliable as a gauge of risk.

Leverage is another term for debt that an investor takes on in order to raise the possible return on their investment. Leverage raises an investment's potential adverse risks. The Sharpe ratio will drop sharply and any loss will be greatly exacerbated if the standard deviation increases too much, possibly leading to a margin call for the investor.

What Is a Good Sharpe Ratio?

Generally speaking, Sharpe ratios above 1 are seen as "good," providing excess gains in comparison to volatility. Nonetheless, investors frequently contrast a portfolio's or fund's Sharpe ratio with that of its competitors or industry. Therefore, if the majority of competitors, for example, have ratios above 1.2, a portfolio with a Sharpe ratio of 1 may be deemed inadequate. In other situations, a good Sharpe ratio could be only mediocre or worse.

Pros and Cons of Sharpe Ratio

Conclusion

William F. Sharpe's mathematical formula, the Sharpe ratio, lets investors analyse investment returns and risk. The Sharpe ratio is calculated by subtracting the risk-free rate of return from the expected rate of return and dividing by the asset's standard deviation.

Investors commonly evaluate investment success using the Sharpe ratio. Easy ratio calculation and interpretation contribute to its popularity. Mutual funds often include the portfolio's Sharpe Ratio in quarterly and annual performance updates.

Even if calculating expected returns and standard deviation is complicated, any investor can see that the higher the Sharpe Ratio, the better the return compared to risk, making the investment more appealing.

The Sharpe ratio only works for extremely similar products like mutual funds and ETFs that track the same index. Higher Sharpe ratio investments might be more volatile, so investors should be aware.