Sharpe Ratio in Mutual Fund

November 17, 2023

Sharpe Ratio In Mutual Fund

The Sharpe Ratio in a mutual fund helps evaluate risk-adjusted returns. In simpler terms, it tells you whether the returns you’re getting are worth your risk. This measure is crucial for investors who want a balanced view of reward and risk.

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What Is Sharpe Ratio In Mutual Fund?

The Sharpe Ratio is a measure that quantifies the risk-adjusted performance of a mutual fund. It helps understand how much excess return you’re getting for the extra volatility or risk you take by holding a riskier asset.

To dig deeper, consider a mutual fund that promises higher returns. A higher Sharpe Ratio would mean that the extra returns compensate for the increased risk, making it a potentially good investment. For instance, a Sharpe Ratio of 1.3 would indicate that the fund generates 1.3 units of return for every unit of risk, making it a more favorable choice for risk-averse investors.

Sharpe Ratio Example

In an example, if a mutual fund has an average return of 12%, a risk-free rate of 3%, and a standard deviation of 10%, the Sharpe Ratio would be calculated as 12%-3%/10%=0.9. A Sharpe Ratio of 0.9 indicates that the fund provides 0.9 units of return for each unit of risk.

Sharpe Ratio Formula – How To Calculate Sharpe Ratio?

The formula for calculating the Sharpe Ratio is:

Sharpe Ratio= Average Return−Risk-Free Rate / Standard Deviation

To understand this better, let’s apply our previous example. The average return is 12%, the risk-free rate is 3%, and the standard deviation is 10%. Plugging these into the formula, the Sharpe Ratio would be 12−3 / 10 = 0.9. A Sharpe Ratio of 0.9 suggests that the mutual fund provides 0.9 units of return for each unit of risk.

Sortino Ratio Vs Sharpe Ratio

The key difference between the Sortino and Sharpe Ratios lies in the type of risk they measure. While the Sharpe Ratio considers both upside and downside volatility, the Sortino Ratio focuses exclusively on downside risk.

ParameterSortino RatioSharpe Ratio
Risk MeasurementMeasures only downside riskMeasures both upside and downside risk
Risk PerceptionOnly concerned with negative volatilityViews all volatility, positive or negative, as risk
Ideal UserInvestors wary of potential lossesThose wanting an overall risk assessment

What Is A Good Sharpe Ratio?

A Sharpe Ratio between 1 and 2 is often seen as “good,” while anything above 2 is “excellent.”

What Is Sharpe Ratio In Mutual Fund – Quick Summary

  1. Sharpe Ratio in mutual funds is a metric that evaluates risk-adjusted returns and is useful for making informed mutual fund choices.
  2. Sharpe Ratio measures how much excess return you get for each unit of risk, which is essential for comparing mutual funds.
  3. Sharpe ratio helps to understand real-world fund performance, which is calculated using average returns, risk-free rate, and standard deviation.
  4. Sharpe Ratio Formula: (Average Return − Risk-Free Rate) / Standard Deviation
  5. Sharpe ratio considers both upside and downside risk, whereas Sortino ratio focuses only on downside risk.
  6. Generally, a Sharpe ratio above 1 is good, offering adequate returns for the risk taken.
  7. Start your investment journey for free with Alice Blue. Alice Blue offers investing in equity, mutual funds, and IPOs completely free of cost.

Sharpe Ratio In Mutual Fund – FAQs

What Is Sharpe Ratio In Mutual Fund?

The Sharpe Ratio is a financial metric that provides insight into the risk-adjusted performance of a mutual fund. 

Which is better Sortino and Sharpe ratio?

Both ratios have their merits, and the better choice depends on your investment goals. The Sharpe Ratio gives you a more general view, considering both the upside and downside volatility. Sortino Ratio, on the other hand, focuses solely on downside risk, which may be preferable if you’re particularly risk-averse.

What is the formula for Sharpe and Sortino ratio?

For Sharpe, the formula is 

(Average Return − Risk-Free Rate) / Standard Deviation

For Sortino, it’s (Average Return − Risk-Free Rate) / Downside Deviation.

Both formulas help investors gauge the risk-adjusted returns, albeit from different angles.

What is a good Sharpe ratio?

A Sharpe Ratio between 1 and 2 can be considered good, while anything above 2 is excellent.

What is the main advantage of the Sharpe ratio?

The Sharpe Ratio’s main advantage is its ability to offer a risk-adjusted view of an investment’s performance. It looks at the potential returns and accounts for the volatility or risk associated with those returns. 

How do I calculate my Sharpe ratio?

You can calculate the Sharpe Ratio by taking the average return of your investment, subtracting the risk-free rate, and then dividing the result by the investment’s standard deviation.

What is the difference between CAGR and Sharpe ratio?

The primary difference between CAGR (Compound Annual Growth Rate) and the Sharpe Ratio is that CAGR measures the mean annual growth rate of an investment over a specified time period longer than one year, while the Sharpe Ratio evaluates the performance of an investment compared to a risk-free asset, after adjusting for its risk. 

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