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SHARPE RATIO the Sharpe Ratio Is One of the Five Risk SHARPE RATIO The Sharpe ratio is one of the five risk assessment ratios, and is beneficial in calculating the risk- return profile of a mutual fund/stock. It is a statistical measure used in Modern Portfolio Theory (MPT). The Sharpe ratio is a measure for calculating risk-adjusted return and it has become the industry standard for such calculations. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. It is a way to examine the performance of an investment by adjusting for its risk. The ratio measures the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk (or deviation risk measure). Now, the Sharpe ratio is calculated as following: Sharpe ratio= Mean Portfolio return – Risk-free rate Standard Deviation of portfolio return The ex-ante (future) Sharpe ratio formula uses expected returns while the ex-post Sharpe ratio uses the realized returns. The Sharpe ratio characterizes how well the return of an asset compensates the investor for the risk taken. When comparing two assets versus a common benchmark, the one with a higher Sharpe ratio provides better return for the same risk (or, equivalently, the same return for lower risk). However, like any other mathematical model, it relies on the data being correct. Now, for an example if I invest i a zero risk iestet (for hih expeted returs are risk-free totally) like government bonds or schemes then my Sharpe ratio is exactly zero. Generally the greater the value of Sharpe ratio, the more attractive is the risk-adjusted return. Note: When examining the investment performance of assets with smoothing of returns (such as with-profits funds) the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund returns. The Sharpe ratio is often used to rank the performance of portfolio or the mutual fund managers. Modern Portfolio Theory states that adding assets to a diversified portfolio that have correlations of less than one with each other can decrease portfolio risk without sacrificing return. Such diversification will serve to increase the Sharpe ratio of a portfolio. Interpreting the Sharpe ratio: The Sharpe ratio can also help explain whether a portfolio's excess returns are due to smart investment decisions or a result of too much risk. Although one portfolio or fund can enjoy higher returns than its peers, it is only a good investment if those higher returns do not come with an excess of additional risk. The greater a portfolio's Sharpe ratio, the better its risk- adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analysed. Limitations of Sharpe ratio: It can be inaccurate when applied to portfolios or assets that do not have a normal distribution of expected returns i.e. hose returs dot hige aroud their ea ut fluctuate to a large extent. The Sharp ratio also tends to fail when analysing portfolios with significant non-linear risks, such as options or warrants. The Sharpe ratio can also be "gamed" by hedge funds or portfolio managers seeking to boost their apparent risk-adjusted returns history. This can be done by lengthening the measurement interval, not calculating standard deviations from compounded monthly interests, writing out of money puts and calls on the portfolio, and also eliminating the best and the worst monthly returns every year, thus smoothing his returns. For practical aspects, please register yourself online for our specialised learning programme.Quality Circle Programme- conducted to educate investors. Prateek Saini Senior Wealth Manager BFC Capital Pvt. Ltd .
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