Sharpe Ratio

This formula, worked by Nobel Laureate Bill Sharpe, tries to quantify how a fund performs relative to the risk it takes. Take a fund's returns in excess of a guaranteed investment (a 90-day T-bill) and divide by the standard deviation of those returns. The bigger the Sharpe ratio, the better a fund performed considering its riskiness. The ratio itself doesn't tell itself anything, Investor has to compare it with the Sharpe of other funds. But this ratio has an advantage over alpha because it uses standard deviation instead of beta as the volatility variable, and therefore you don't have to worry that a fund doesn't relate well to the chosen index.

The Sharpe ratio represents trade off between risk and returns. At the same time it also factors in the desire to generate returns, which are higher than those from risk free returns. Mathematically the Sharpe ratio is the returns generated over the risk free rate, per unit of risk. Risk in this case is taken to be the fund's standard deviation. As standard deviation represents the total risk experienced by a fund, the Sharpe ratio reflects the returns generated by undertaking all possible risks. It is thus one single number, which represents the trade off between risks and returns. A higher Sharpe ratio is therefore better as it represents a higher return generated per unit of risk.

Sharpe ratio provides an unbiased look into fund's performance. This is because they are based solely on quantitative measures. However, these do not account for any risks inherent in a funds portfolio. For example, if a fund is loaded with technology stocks and the sector is performing well, then all quantitative measures will give such a fund high marks. But the possibility of the sector crashing and with it the fund sinking is not calculated. In view of these possibilities quantitative tools should be used along with information on the nature of the funds strategies, its fund management style and risk inherent in the portfolio. Quantitative tools can be used for screening but they should not be the only indicator of a fund's performance.

The Sharpe ratio is one of the most useful tools for determining a fund's performance. Since Sharpe Ratio is a measure of risk-adjusted returns, a high Sharpe Ratio is good.