When you decide to buy a car what is it that you evaluate?
Is it only speed? size? Automatic driving? fuel efficiency… or style, snob value, & other specific features (like four-wheel drive) etc.?
- Chances are you look at most of these parameters before buying a car!
- Similarly, even in a mutual fund scheme the buying decision should not be a function of a single parameter.
- But, unfortunately most of us only look at “Returns” while evaluating a scheme
- As we all know, risk and return go hand in hand with investments.
- The higher the risks, the higher the gains and vice versa.
- So, when you look at returns in an isolated manner, it becomes difficult to compare them as one does not get an idea of the risk taken to achieve these returns.
Hence, would you put in your hard-earned money in a scheme that is No. 1 today but could disappear out of sight tomorrow, or would you put it on a scheme that is No. 3 but will maintain its position in the long run?
- Therefore, reliability of the scheme is a critical aspect.
- In the context of mutual fund scheme’s reliability is nothing but volatility.
- A scheme on one hand may give good returns but on the other hand if it turns out to be volatile or unreliable may not find favour with investors.
- Hence this calls for a measure of performance which takes into account both returns as well as volatility / reliability.
Sharpe Ratio is one such parameter which is both relevant and extremely significant while describing a fund’s characteristics.
Sharpe Ratio expresses the relationship between performance of a scheme and its volatility.
Mathematically it can be expressed as:
Sharpe ratio = Average returns / Volatility
Therefore, it becomes important to evaluate the returns of the schemes for the same amount of risk.
Let me give you an example:
Say you wish to compare the performance of two students A & B in their annual exams.
Student A gets scores of 85, 60, 45, 100 & 60.
Student B, on the other hand, gets scores of 70, 75, 60, 60 & 80.
Who do you think performed better?
If we calculate their averages,
- Student A: 85 +60+ 45 +100 + 60/ 5 = 350/5 = 70
- Student B: 70 +75+ 60 +60 + 80/ 5 = 345/5 = 69
Here it looks like A performed better, right?
- Though Student A could have a better average than B, his volatility seems higher.
- His scores range from 100 to 45. Upon calculating, his volatility comes to 19.74.
- Student B on the other hand did not deliver spectacularly in any particular subject, but he performed steadily. Upon calculating, his volatility comes to 8.
Calculation for volatility is not part of this.
Hence the Sharpe Ratio of A would be: 70/19.74 = 3.54
And the Sharpe Ratio of B would be: 69/8 = 8.62
Thus, despite a higher average, A’s Sharpe ratio is lower than that of B.
This indicates that simply looking at performance from average marks point of view is not enough to judge performance.
This is what Sharpe Ratio does.
In a sense it measures performance by making their volatilities equal across schemes.
In a sense Sharpe ratio helps to compare apples to apples instead of apples to oranges.
The Sharpe ratio thus provides the returns of the schemes per unit risk and tells us whether a fund’s returns are due to smart investment decisions or as a result of excess ‘risk’.
