What does one desire from one's investments? The obvious answer seems to be returns. And not just any returns but the higher the better. While an investor seeks to generate high returns the question arises, how high? Though the sky can be the limit, usually one asks for returns, which are higher than those, which we are normally accustomed to. These are returns from risk-less instruments like treasury bills, government securities or bank savings deposits. So the aim of investing seems to be to generate returns in excess of the risk free return. And in order to generate these higher returns we are willing to take risks.
At the same times high returns are generally associated with a high degree of volatility. We accept this volatility only because we want higher returns. The Sharpe ratio represents this trade off between risk and returns. At the same time it also factors in the desire to generate returns, which are higher than those from risk free returns.
Mathematically the Sharpe ratio is the returns generated over the risk free rate, per unit of risk. Risk in this case is taken to be the fund's standard deviation. As standard deviation represents the total risk experienced by a fund, the Sharpe ratio reflects the returns generated by undertaking all possible risks. It is thus one single number, which represents the trade off between risks and returns. A higher Sharpe ratio is therefore better as it represents a higher return generated per unit of risk.
However, while looking at Sharpe ratio a few points have to be kept in mind to obtain an accurate reading of the fund's performance. Firstly, being a ratio, the Sharpe measure is a pure number. In isolation it has no meaning. It can only be used as a comparative tool. Thus the Sharpe ratio should be used to compare the performance of a number of funds. Alternatively one can 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 the peer group performance. The Sharpe ratio uses standard deviation as it's risk component, a low standard deviation can unduly influence results. Thus 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 not generate high returns. For an investor who puts in all his/her money in a single fund, Sharpe ratio is a useful measure of risk-adjusted return. This is because standard deviation measures total risk and this is the case with a single portfolio. For additional funds in a portfolio, indicators like the Treynor ratio, which use market risk, can be used.
Measures such as Sharpe ratio provide an unbiased look into fund's performance. This is because they are based solely on quantitative measures. However, these do not account for any risks inherent in a funds portfolio. For example, if a fund is loaded with technology stocks and the sector is performing then all quantitative measures will give such a fund high marks. But the possibility of the sector crashing and with it the fund sinking is not calculated. In view of these possibilities quantitative tools should be used along with information on the nature of the funds strategies, its fund management style and risk inherent in the portfolio. Quantitative tools can be used for screening but they should not be the only indicator of a fund's performance.
The Sharpe ratio is one of the most useful tools for determining a fund's performance. This measure is used the world over and there is no reason why you as an in investor should not use it. So sharpen the analysis of your fund's performance with the Sharpe Ratio.