Sharpe Ratio - Meaning, Advantages & Limitations

 

Sharpe Ratio - Meaning, Advantages & Limitations

What is Sharpe Ratio?

The Sharpe ratio is named after American economist, William Sharpe, the Sharpe Ratio (or Sharpe Index or Modified Sharpe Ratio) is commonly used to measure the excess portfolio return over the risk-free rate relative to its standard deviation.
The higher the ratio, the greater the investment return relative to the amount of risk, thus the better the investment. This ratio is used to evaluate a single stock or investment, or an entire portfolio.

Sharpe Ratio Formula
Sharpe Ratio = (Rx – Rf)/ StdDev Rx
Where:
• Rx = Expected portfolio return
• Rf = Risk-free rate of return
• StdDev Rx = Standard deviation of portfolio return (or, volatility)


Importance of Sharpe Ratio

Sharpe Ratio in mutual funds plays a significant role in generating returns and recognizing the risk and reward ratio. It helps to identify the risk level and return rate of all mutual funds
Here are some advantages of the Sharpe Ratio as follows:
• Analyse the fund’s performance
The Sharpe Ratio help’s investors to analyse the fund performance by looking at this ratio, the investors can evaluate the level of risk in comparison with the extra returns. This calculator can be used to analyse funds operate with growth style.
• Risk-adjusted return calculator
With this ratio, investors can calculate the risk factors before starting investing. Existing investors transfer their investment if their present fund gains a low Sharpe Ratio.
• Helps in fund Comparison
Beginners can compare this ratio to identify their risk factors and adjusted-return rates.
• Study the portfolio diversification
Investors can use the ratio as a tool to identifying the portfolio diversification.
• Examine the risk and return rate
Fund having higher Sharpe ratio is considered to have a higher return and risk. Therefore, investors aiming to earn higher returns tend to choose funds with a higher ratio.


Limitations of Sharpe Ratio

Despite having major advantages, the Sharpe ratio also have some limitations are as follows:
1. Sharpe Ratio of a fund does not take any responsibility for risk of managing portfolio and does not reveal whether the fund is dealing with single or multiple factors market factors.
2. The portfolio managers influence the Sharpe ratio.
3. Sharpe ratio is used to evaluate a mutual fund which is not a good strategy.


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