Sharpening Skills

The downside risk of investing is a reality that must be given due importance. As is widely accepted, high returns are generally associated with a high degree of volatility. For this purpose the performance of a portfolio must be viewed with respect to the risk assumed. It is here that the Sharpe Ratio comes in handy. For the Sharpe Ratio assesses the return generated by a portfolio, per unit of risk undertaken. Risk in this case is taken to be the portfolio's standard deviation. Standard deviation is used as it is indicative of the volatility in the fund. A lower standard deviation implies little fluctuation in the returns.

Mathematically, the Sharpe Ratio is the difference between the portfolio's returns over and above the return earned on a risk free investment divided by the standard deviation of the portfolio. A higher Sharpe Ratio is therefore better as it represents a higher return generated per unit of risk.

This process of comparing the risk adjusted returns of two portfolios, gives us an insight into the efficiency of fund management as well. Because a portfolio could deliver superlative returns by assuming significant risk, but a superior portfolio is arrived at when the manager is able to rationalise the amount of risk taken to deliver high returns.

However, while looking at Sharpe ratio, please keep in mind that in isolation it has no meaning. It can only be used as a comparative tool. Thus the Sharpe ratio should be used to compare the performance of a number of portfolios or funds. In case of mutual funds, one can compare the Sharpe ratio of a fund with that of its benchmark index. If the only information available is that the Sharpe ratio of a fund is 1.2, no meaningful inference can be drawn as nothing is known about the peer group performance. Another aspect to look out for is that the ratio can be misleading at times. For example, a low standard deviation can unduly influence results. A fund with low returns but with a relatively mild standard deviation can end up with a high Sharpe ratio. Such a fund will have a very tranquil portfolio and not generate high returns.