‘Sharpe’n your Mutual Fund investments

Sep, 2001

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A s with all investments, mutual funds also have an associated risk component. Hence in deciding which fund to invest in, it is not enough to check out just the fund’s total return. The risk involved should also be considered.

Sharpe Ratio, a risk-adjusted measure developed by William Sharpe, is a widely used tool in selection and comparison of mutual funds. The ratio considers not only the performance of the fund, but also the risk involved. The higher a fund’s Sharpe Ratio, the better the fund’s returns, relative to the risk it has taken on. Let us understand how to determine the ratio.

Determining the Ratio

First, the average returns for the fund over a specified time period, say daily, weekly, monthly etc. are calculated. The average returns for the benchmark index or instrument for the same period is also calculated. A positive difference between the Fund’s returns and the benchmark returns, shows that the fund has generated returns in excess of the benchmark returns.

To find out how much risk the fund manager has taken to generate these returns, the difference is divided by the standard deviation of the Fund’s returns.

Take the example of two equity funds, X and Y. Fund X generates returns of 16.4 percent for the year 2001, with a standard deviation of returns of 10 percent. Fund Y generates 18 percent returns with a standard deviation of 15 percent. The benchmark Nifty returns over the same period is 10 percent.

Sharpe Ratio for X is 0.64 [(16.4 – 10)/10] while the ratio for Y is 0.533 [(18 – 10)/10].

Without the help of Sharpe Ratio, you would have selected Fund Y as it has generated higher returns. But, if risk-adjusted returns are to be considered, Fund X is better than Fund Y. The Sharpe Ratio ratio, however, shows that Y assumed a far higher risk to generate additional return of 1.6 percent. In other words Fund X has performed well on a risk-adjusted basis.

The higher a fund’s Sharpe ratio, the better the fund’s returns, relative to the risk it has taken on. Because the ratio uses standard deviation, it can be used to compare risk-adjusted returns across all fund categories.

So, the next time you choose a mutual fund, remember to arm yourself with the Sharpe Ratio.

A Srilakshmi

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