For a potential investor just beginning in mutual funds, there is a wide array of qualitative and quantitative analysis tools to use. These tools help gain a better understanding on what to expect in risks and returns. The question becomes the matter of which funds to purchase and which funds to avoid. There is also the matter of seeing if the investor will be well compensated for the risks taken. In this particular case, one of the primary formulas for comparing risk-adjustment performance is the Sharpe Ratio.

Investing in Mutual Funds

Putting cash in savings account can seem smart. What usually happens, though, is that the savings accounts have extremely low interest rates. The cash sitting in the savings account isn’t given very much opportunity to grow. For many, that cash is wasted away or spent. The next best thing is mutual funds. Mutual funds are generally a collection of stocks and bonds. There are three ways to financially benefit from mutual funds. First off, the earnings come from dividends on stocks and interest on bonds. Second, if it sells securities, there is capital gain. And last but not least selling the investor’s share for profit would a good idea only if the price of the fund’s shares has risen. The positives derived from investing in mutual funds are diversification, liquidity, and simplicity. On the opposite side of the coin is that it can be expensive, the diversification can be too much, and there are taxes involved.

The Risk-Free Rate

The Returns

When there is a risk, there is a return. In assessing investments, it is common knowledge that the return is income earned off of the assets. The return is expressed in an equation as a capital R with a subscript x. The returns measured can be of any frequency, such as daily, monthly, or annually. In any frequency, the returns should be distributed normally. The negative of measuring returns in any ratio is that not all asset returns are normally distributed.

Defining the Sharpe Ratio

There are several ways to rank performances of a portfolio or mutual fund managers. One is the alpha, which takes the volatility of a security or fund portfolio and compares it to a benchmark index. There is also the beta coefficient, usually just known as beta, which takes the volatility and compares it to the market as a whole. Sharpe ratio, on the other hand, measures an investment’s excess return per unit of risk.

The Sharpe Ratio Formula

The formula includes three important variables. These variables are the investment’s return, the risk-free rate of return, and standard deviation. The investment’s return is indicated in several ways. The return can be shown as capital R subscript x. It can also be shown as Capital R subscript f. R subscript is the annualized return of assets. The risk-free rate of return is usually shown as capital R subscript f. Finally, the standard deviation also has several indicators. It can be shown as StdDev(x). It is also symbolized by the Greek letter sigma. Sometimes, it is also expressed as a Greek letter sigma followed by a subscript of the letter a. The Sharpe Ratio of Asset is expressed with either S(x) or capital S subscript a.

An Example of Using the Ratio