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Sharpe Ratio
Sharpe ratio evaluates the performance of a portfolio based on the total risk of a portfolio. It measures the excess return generated by a portfolio over the risk free rate in relation to the total risk or standard deviation of a portfolio.
Sharpe Ratio= (Rp - Rf)/σ
Where, Rp=return on the portfolio, Rf= risk free rate and ?= standard deviation of the return of the portfolio
Higher the Sharpe ratio, better is the fund.
Illustration: Consider two funds A and B. Let return of fund A be 30% and that of fund B be 25%. On the outset, it appears that fund A has performed better than Fund B. Let us now incorporate the risk factor and find out the Sharpe ratios for the funds. Let risk of Fund A and Fund B be 11% and 5% respectively. This means that the standard deviation of returns - or the volatility of returns of Fund A is much higher than that of Fund B.
If risk free rate is assumed to be 8%,
Sharpe ratio for fund A= (30-8)/11=2% and
Sharpe ratio for fund B= (25-8)/5=3.4%
Higher the Sharpe Ratio, better is the fund on a risk adjusted return metric. Hence, our primary judgement based solely on returns was erroneous. Fund B provides better risk adjusted returns than Fund A and hence is the preferred investment. Producing healthy returns with low volatility is generally preferred by most investors to high returns with high volatility. Sharpe ratio is a good tool to use to determine a fund that is suitable to such investors.
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