Information, when not put in perspective, can be misleading. Returns churned up by a fund or a portfolio are one example. It is often assumed that high returns mean better performance. While this may be true in some cases, the real picture of a portfolio's performance can be gauged only when the returns it generates are assessed with respect to the risk it assumes.
This is where the Sharpe Ratio comes in handy. The downside risk of investing is something that must be duly considered. While investors often associate high returns with a high degree of volatility, this is not always the case. This is why any good analysis of a portfolio must view its returns in the light of its risk factor. The Sharpe Ratio assesses the returns generated by a portfolio against each unit of risk undertaken.
Mathematically, the Sharpe Ratio is the difference between the portfolio's returns and the return earned on a risk free investment, divided by the standard deviation of the portfolio. The standard deviation is the risk factor of the portfolio and is indicative of the volatility of the fund. A lower standard deviation implies little fluctuation in returns. So the higher the Sharpe Ratio, the better, since a high Sharpe Ratio represents a higher return generated per unit of risk.
In isolation, however, the Sharpe Ratio of a portfolio or fund has little use. It must only be used as a comparative tool to evaluate the performance of a number of portfolios or funds. In the case of mutual funds, one might compare the Sharpe ratio of a fund with that of its benchmark index. If the only information available is that the Sharpe ratio of a fund is 1.2, no meaningful inference can be drawn as nothing is known about peer group performance.
Something else to watch out for is the possibility that a fund's Sharpe Ratio may be misleading. For instance, a low standard deviation can unduly influence results. A fund with low returns but with a relatively mild standard deviation can end up with a high Sharpe ratio. Such a fund will have a very tranquil portfolio and will not generate high returns.
To sum it up, a Sharpe Ratio will invariably tell you which of the portfolios under comparison is performing to the best of its abilities. You can easily find the Sharpe Ratio of a fund on VRO. There are two ways:
1. Visit a fund page after locating it using the search bar at the top of the site. Then go to the Performance tab. Under it, you will find a category called Risk Measures. This table includes the Sharpe Ratio of the fund as well that of its category and benchmark index among the variables listed.
2. Select a fund category from the list provided towards the bottom of the home page. Next, go to the Risk Stats tab to find the Sharpe Ratio of different funds. See below.
This story originally appeared in May 2008.