Sharpe ratio is a metric that can help you compare investments from a risk-adjusted return perspective. Learn about calculating Sharpe ratios here.
Understand the difference between rate of return and risk-adjusted return
Learn how to calculate the Sharpe ratio
Know what the Sharpe ratio measures and how you can use it to help make investment decisions
Here’s a tricky scenario you might have encountered: You come across two similar exchange-traded funds (ETFs). Assume they have similar holdings. Their share prices are roughly the same, and so are their expense ratios. Their comparative performance over the same period almost matches—both generate a 15% return.
Yet despite their similarities, one of them might be a better investment—a bigger bang for your buck, so to speak. But how can you possibly know that if the overall cost, portfolio holdings, and performances are nearly identical?
A way to distinguish one from the other would be to take into account an asset’s volatility or “risk.” In other words, which fund might give you more reward per unit of risk?
The answer to that specific question might be found in the fund’s Sharpe ratio.
The Sharpe ratio is a ratio that measures how an asset performed relative to a risk-free asset. In other words, it helps measure an investment’s excess return relative to its total risk. Or, to put it more simply, it tells you how much bang you’re getting for your buck despite the asset’s actual returns.
What does that mean, exactly? Here’s an example: If a managed fund ABC has an annual return of 20% and another managed fund XYZ has a return of 15%, then you might assume ABC is the better investment based on its performance.
But don’t be so quick to judge. Looking at a fund’s rate of return may not be enough to provide the complete picture. It may help to look at a fund’s risk-adjusted return as well. If fund ABC’s Sharpe ratio is at 0.05 while Fund XYZ’s ratio is at 0.75, then it tells you the lower-performing fund may be the better investment. How so? It depends—there are many factors at play. Perhaps ABC was the riskier investment that just happened to achieve higher returns, while XYZ, though achieving a smaller return, did so more efficiently and with less risk. Perhaps ABC’s fund manager took more risks than XYZ’s, which doesn’t necessarily make it a “better” investment, just a riskier one that happened to return more this time around.
To better understand the Sharpe ratio, let’s look at how it’s calculated.
Let’s say you’re looking to measure the Sharpe ratio of Fund XYZ that’s expected to return 14% in a given time period, say in a year. For your risk-free rate proxy, you’ll use an ETF of Treasury Inflation Protected Securities (TIPS), which yields 2.70%. Let’s suppose Fund XYZ’s volatility is 20% (you’d plug this into the denominator).
The Sharpe ratio formula:
Average expected return of the investment – Risk-free return / Standard deviation of returns
If you plug in the numbers, (0.14 – 0.027) / 0.20, you’ll get a Sharpe ratio of 0.56.
Now, suppose you have another fund that has the same return but with a volatility of 10%. Its Sharpe ratio would be higher at 1.13. The lower volatility increased the risk-adjusted return of this fund. According to theory, the higher the ratio, the “better” the returns relative to the risks.
It’s not foolproof. But if you’re looking to get a clearer picture of an asset’s risk-adjusted return, the Sharpe ratio can be useful in providing a snapshot from that particular angle.
The nice thing about this ratio is that it provides you with a single figure you can use to compare with other potential investments. The higher the ratio, the better—there’s no good or bad Sharpe ratio. This means you can line up different potential investments’ ratios side by side to determine which asset’s risk-to-return profile might be more optimal. Still, the ratio has its limitations.
The Sharpe ratio isn’t a panacea for analyzing all potential investments. Big picture changes in the fundamental market or economic environment may affect a fund’s performance in the near-term to long-term future. As you probably know, past results don’t necessarily indicate future results.
Another tricky limitation of the Sharpe ratio is, ironically, embedded in one of its strongpoints: its use of standard deviation. Some experts would argue that a standard deviation assumes all fluctuations, whether up or down, to be of equal risk. You know from experience that some risk factors can be significantly riskier than others. It’s not in the Sharpe ratio’s design to tell the difference—it doesn’t provide you with a well-rounded picture of risk.
Standard deviations can also differ when applied to daily, weekly, or monthly returns. Who’s to say a fund manager won’t choose, say, daily returns (versus weekly or monthly returns) to generate a higher Sharpe ratio?
Last but not least, what if you want the more volatile asset as a smaller allocation in your portfolio? In this case, a lower Sharpe ratio with a higher market return might be more suitable for your smaller but more speculative allocations.
When it comes to analyzing investments, it’s arguably important to consider both risk and return. That seems like a no-brainer. Yet many investors tend to focus too much on one or the other depending on their risk aversion. At its best, the Sharpe ratio can help you decide on the investment that might deliver the highest risk-adjusted returns. And that knowledge can help you better steer the direction of your portfolio based on your financial goals and risk tolerance.
TD Ameritrade tools and services can help you decide.
Karl Montevirgen is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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