Ratios to Consider while Choosing Mutual Fund Schemes

Investing by considering only historical returns in a mutual fund scheme is risky. Investors need to evaluate the risk involved in mutual fund schemes before investing. There are no. of ratios which mutual fund investors should consider before making their investments. In this article we will cover Sharpe ratio

Definition: Sharpe Ratio measures how well the fund has performed vis-a vis the risk taken by it. It is the excess return over risk-free return (usually return from treasury bills or government securities) divided by the standard deviation. The higher the Sharpe Ratio, the better the fund has performed in proportion to the risk taken by it. The Sharpe ratio is also known as Reward-to-Variability ratio and it is named after William Forsyth Sharpe. 

Computation: SR = (TOTAL RETURN – RISK FREE RATE) / STANDARD DEVIATION OF FUND

 The Sharpe Ratio is calculated by taking the return of the portfolio and subtracting the risk-free return, then dividing the result (the excess return) by standard deviation of the portfolio returns. 

Basically, it is measuring excess return (over risk-free rate) per unit of risk. If Sharpe ratio is 1.25 p.a., then it implies 1.25%p.a. excess return for 1% annual volatility.

 For example: Your investor gets 7 per cent return on her investment in a scheme with a standard deviation/volatility of 0.5. We assume risk free rate is 5 per cent. Sharpe Ratio is 7-5/0.5 = 4 in this case.

 Significance 

• The greater a portfolio's Sharpe Ratio, the better its risk-adjusted performance. A negative Sharpe Ratio indicates that a risk-less asset would perform better than the security being analyzed. 

• This measurement is very useful to compare funds with similar returns or high returns, by analyzing the same in line with the risk taken. 

• Risk-adjusted financial performance of investment portfolios or mutual funds is typically measured by Sharpe's ratio. From an investor's point of view, the ratio describes how well the return of an investment compensates the investor for the risk he takes.