What It Means
The Sharpe Ratio measures how much return a fund generated for each unit of risk (volatility) it took on. Two funds can post the same headline return, but the one that got there with a smoother ride has the higher Sharpe Ratio, and is doing more with less risk.
How It Works
It's calculated as the fund's return in excess of the risk-free rate (usually a government bond or T-bill yield), divided by the fund's standard deviation, its measure of how much returns swing around their average. A higher Sharpe Ratio is better; a fund with a Sharpe of 1.2 delivered more return per unit of risk than one with a Sharpe of 0.6, even if the second fund posted a higher absolute return.
Sharpe Ratio = (Fund Return - Risk-Free Rate) / Standard Deviation of Fund Return
- Fund Return
- The fund's return over the period measured
- Risk-Free Rate
- The return on a virtually risk-free instrument, like a government T-bill
- Standard Deviation
- How much the fund's returns swing around their own average
Warning
A common mistake is comparing Sharpe Ratios across very different fund categories, say a liquid fund against a small-cap equity fund. The ratio is only meaningful when comparing funds that take on a similar kind of risk in the first place.