How to measure risk and return of mutual fund using Sharpe ratio?

Investing seems to be confusing and difficult with so many investment avenues available in the market. Many a time, investors get confused while investing in the hope of receiving optimum returns with lower risk. As everyone knows, the higher the risk, the higher is the return.  

So, how are these risks and returns measured? Risk is measured using a statistical tool known as standard deviation while returns are measured considering risk, known as Sharpe ratio. The higher the risk, the higher is the standard deviation & higher volatility or variation, and vice versa, which in turn, leads to higher return & higher Sharpe ratio. In this article, we are going to take a look at how Sharpe ratio is used in the case of mutual funds.  

Sharpe ratio was developed by Nobel Laureate William F. Sharpe, an American economist. He used this ratio to help investors understand the return on investment compared to risk. Sharpe ratio measures the potential risk-adjusted returns of the mutual funds. Risk-adjusted returns are the returns earned by an investment over the returns generated by any risk-free asset such as a fixed deposit. The higher the Sharpe ratio, the higher are the returns and the risk. Investors aiming for higher returns should choose to invest in the funds with a higher Sharpe ratio whereas, if Sharpe ratio is negative, then it's better to invest in risk-free instruments.  

How is Sharpe ratio calculated?  

Sharpe ratio is calculated using the following formula:   

Standard deviation depicts how much fund is deviating from its average return. This tool measures the risk in the portfolio.  

Sharpe ratio denotes the degree of returns generated, considering all types of risks. Investors willing to earn returns higher than fixed-income instruments should invest in the funds with a higher Sharpe ratio.  

Mutual fund comparison:  

This ratio can be used to compare the two mutual funds by comparing their returns along with their risk levels. For instance, if fund X offers higher returns with a higher risk and fund Y offers the same return as fund X but has lower risk as compared to fund X, then you should consider investing in fund Y as it offers higher returns with lower risk as compared to fund X.  

Comparison against the benchmark:  

Sharpe ratio helps to compare returns of the fund against its underlying benchmark. This way, you come to know whether your fund is underperforming or outperforming the benchmark.   

What is a good Sharpe ratio?  

Generally, Sharpe ratio greater than 1 is considered satisfactory to good investors. A ratio higher than 2  is rated as very good, higher than 3  as excellent while a ratio less than 1  is considered inferior or suboptimal.  

Limitations of Sharpe ratio:  

Sharpe ratio does not account for portfolio risk. This ratio is calculated using standard deviation, a substitute for portfolio risk, which considers that returns are normally distributed and do not show whether the fund is investing in a single sector or various sectors.  

So, before investing in any mutual fund, investors shouldn’t completely rely on Sharpe ratio. They should consider other ratios or measures as well.  

Following table depicts the average Sharpe ratio of equity-oriented funds: