All You Need to Know About the Sharpe Ratio in Mutual Funds

• 'The essence of investment management is the management of risks, not the management of returns.' - Benjamin Graham, The Intelligent Investor

Mutual funds have proved to be a potent avenue for wealth creation over the long term. However, you cannot select mutual funds solely by their past returns.

Keep in mind that for a certain level of return generated by a fund, there is a certain degree of risk involved. Risk and return are two sides of the same investment coin.

While it is often perceived that the higher the risk, the higher the return, in reality, it does not always hold true.

In case of equity mutual funds, there have been instances where the scheme has taken higher risk than its category peers but has lagged in delivering risk-adjusted returns.

Hence, you need to be conscious of the risk involved and not simply go by returns. Manage risk sensibly instead of avoiding it. In other words, there ought to be a suitable risk-return trade-off.

To evaluate the risk-adjusted returns of two or more similar mutual funds, the Sharpe Ratio is commonly used.

What is Sharpe Ratio?

The Sharpe Ratio (SR) was named after an American economist, William F. Sharpe, who proposed it in 1966.

It's calculated by first taking the difference between the returns of the investment (Ri) and the risk-free return (Rf). This difference is divided by the standard deviation (SD) of the portfolio to arrive at the SR.

Sharpe Ratio = (Fund Return - Risk-free Return) / Standard Deviation of the Fund

The higher the sharpe ratio, the better the fund's ability to reward investors with higher risk-adjusted returns.

For the risk-free return, usually, the 10-year G-sec yield is considered.

Standard deviation (SD) denotes the risk taken by the fund's portfolio to achieve the returns.

In investing, risk is a result or an outcome that is different from what is anticipated or expected out of an investment. When the outcome is not as expected, it's called a 'deviation' or, in portfolio management parlance, the 'standard deviation.'

The SD is usually calculated over 3 years and indicates how much a fund's return deviated from the average expected return over that time. If Fund A has an SD of 18% and Fund B 15%, it means A is riskier or more 'volatile' than B.

Debt funds are less risky than equity funds due to lower volatility and have a lower sharpe ratio. Within equity mutual funds as well, the risks differ between categories - large cap, mid cap, small cap, multi cap, flexi cap, value, and so on.

If the fund's SD is high and so is its sharpe ratio, it means that it has justified the risk taken.

But if the risk taken hasn't translated into meaningful risk-adjusted returns, it's worth giving a miss.

Risk-Reward Perspective

	Fund A	Fund B
Returns	23%	20%
Risk-free Rate	6%	6%
Std. Deviation	18%	15%
Sharpe Ratio	0.85%	0.93%

(For illustration purposes only)

Fund A has generated a higher return of 23% compared to 20% in the case of Fund B. It may seem that A is better than B, but Fund A is also riskier than Fund B, as denoted by the SD.

Considering this, from a risk-adjusted perspective, fund B has performed better on a risk-adjusted basis compared to fund A.

Now you may ask: What if two schemes of the same category have an identical sharpe ratio?

In such a case, it means that there is no clear advantage of choosing one over the other. You would also need to look at the underlying portfolio of these schemes to make a judgment in that case.

The Sharpe ratio can also be used to compare a scheme's performance against the benchmark index. If there is an outperformance relative to its benchmark index, it means that the fund has been able to generate 'alpha' on a risk-adjusted basis.

Conclusion

While returns play an important role in selecting mutual funds, the risk involved should also be considered. Understanding the Sharpe ratio can help you make a better choice.

When using the Sharpe ratio, be sure to compare apples with apples. Compare funds in the same category when looking at risk-adjusted returns.

Keep in mind, in a rising market, most equity mutual fund schemes perform well, but the true test of managing risk and returns is when the market is moving downward.

It's essential for a mutual fund scheme to keep risk under control and adequately compensate investors on a risk-adjusted basis.

Ideally, you should pick a mutual fund scheme that does not chase high returns by exposing investors to very high risk. Consider those which have shown an overall consistent performance.

Also, choose schemes for your portfolio that align well with your risk profile, broader investment objective, your financial goals, and time horizon.

Invest sensibly and be a thoughtful investor.

Happy Investing.

Disclaimer: This article is for information purposes only. It is not a recommendation and should not be treated as such.