When investing, the allure of stellar returns often becomes the primary driver of decision-making. As investors celebrate a mutual fund scheme that delivers a 15% annual return, only a few stop to ask: at what cost?
At a time when financial markets are turbulent, you need to weigh risks and returns. To understand whether your MF investment is truly performing well or is simply a risky bet delivering dazzling returns, you need a tool that zooms in on the scheme’s risk and reward. This is where the Sharpe ratio comes in handy. Let us understand the tool and how it helps calculate your returns.
What is the Sharpe ratio?
Developed by Nobel laureate William F. Sharpe, the ratio is a tool that measures risk-adjusted returns. Instead of just looking at the final percentage of growth, it examines how much “excess return” an investor receives for the extra risk they take on.
“Simply put, the Sharpe ratio means how much the scheme has generated extra returns compared to the risk taken,” explains Pankaj Mathpal, founder and managing director of Optima Money Managers Pvt. Ltd. “When you want to generate extra returns, it means taking extra risk. And depending on the extra risk taken, you need to get that extra return. If the risk taken is 2% and the return is 1% extra, it does not make sense. The returns in the proportion of the risk should be higher,” he adds.
How the ratio is calculated
To arrive at this number, analysts subtract the “risk-free rate”, which is usually the return on a stable index like the Nifty 50 for equity or government treasury bills for debt, from the fund’s total return. This result, known as the ‘alpha,’ is then divided by the fund’s standard deviation, which represents its volatility.
“For this, one needs to see how much extra returns have been generated by the fund manager as compared to risk-free returns,” says Mathpal. “Compared to these risk-free returns, how much extra returns or alpha were generated and how much risk was taken for that?”
When using the Sharpe ratio, one needs to remember to compare apples to apples, meaning that the ratio needs to be used to compare schemes within the same category. The ratio essentially allows investors to see which fund manager is utilizing their ‘risk’ most efficiently.
“We all know risk and return go hand in hand,” notes Nikhil Kothari, director and co-founder of Etica Wealth Pvt. Ltd. “What the Sharpe ratio checks is risk-adjusted returns. So it breaks down the return on every unit of risk taken. This can be used to compare products, as different products come with different risks.”
Kothari provides a practical example. “If one scheme gives you 14% returns and one gives you 12%, then investors need to see per unit of risk, how much return they get on each. The ones with the higher Sharpe ratio are the better. If one can compare five schemes, then one can know which one has the best Sharpe ratio.”
How to track and use it
Most investment platforms and fund fact sheets list the Sharpe ratio under their “Risk Statistics” section. By tracking the Sharpe ratio, one can steer clear of being a return chaser and become an investor who makes risk-evaluated bets, ensuring that every unit of stress the portfolio is being adequately compensated with gains.
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