Sharpe Ratio is used to measure the return of a portfolio adjusted to the risk taken by the portfolio. William F. Sharpe developed the Sharpe Ratio. The basic idea of the Sharpe ratio is to understand the return a fund gives for additional volatility in the portfolio compared to a risk-free asset such as G-Sec Bonds.
The higher the Sharpe Ratio, the better the fund performance for the volatility factor in that particular portfolio. The lower the Sharpe Ratio, the lower the fund performance for the volatility in that portfolio.
Different factors tell us about the fund's volatility; a few of them are Mean, Standard Deviation, and Beta. Sharpe Ratio uses the standard deviation of the portfolio as a volatility factor.
Sharpe Ratio helps compare funds' returns based on the portfolio's volatility. Suppose a fund 'AAA' has a high Standard Deviation (volatility) of 30%, the fund is generating a return of 18%, and another fund 'BBB' has a volatility of 20%. The fund is generating a return of 16%. Considering risk free rate of 6%, the Sharpe ratio for AAA is 0.4%, and BBB is 0.5%.
Thus, based on the Sharpe ratio, an investor can easily understand that BBB is the better choice when compared to the risk-adjusted returns of both portfolios.
In the above illustration, the portfolio AAA has a 3-Year Standard deviation of 30%, 3 – Year CAGR of 18%, and the risk-free rate is 6%. Then the Sharpe ratio calculation is as follows:
The portfolio BBB has a 3-Year Standard deviation of 20%, 3 – Year CAGR of 16%, and the risk-free rate is 6%. Then the Sharpe ratio calculation is as follows:
Though there are higher returns in the portfolio AAA, due to the higher volatility in the AAA, the risk-adjusted returns are lower than BBB, where actual returns are lower.
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