Sharpe Ratio: One Can Use It To Pick Best Mutual Funds

As investors, we have to always take into account the risk associated with a particular mutual fund. It is true that equity based mutual funds have a higher risk because they invest in the stock market. So it becomes important to find out how much risk you’ll be taking when you invest in a particular mutual fund.When we invest, what is usually our goal? Isn’t our goal to get the best possible returns on our investment with the most minimal possible risk? But how can someone find out what the risk of a particular fund is. Merely looking at the past few years’ returns would give us some idea about how the mutual fund is performing, but it doesn’t paint the full picture. The track record of a mutual fund usually doesn’t show us how much risk your investment was exposed to.That is where the Sharpe Ratio comes in. The Sharpe Ratio is a formula that lets you calculate how much returns you can get on a mutual fund investment as compared to the risk associated with it. In simple terms, the Sharpe Ratio compares your equity investment with a risk-free assetand tells you whether your investment justifies the risk and by how much.

The formula for Sharpe Ratio is as follows:Sharpe Ratio = Re-Rf / SdWhere,Re = Expected ReturnsRf = Risk Free ReturnsSd = Standard Deviation of ReLet us first understand what the terms in the Sharpe Ratio actually mean.

The expected return in the above equation signifies the rate of returns that are expected of a particular mutual fund in the future. For example, if a mutual fund had a rate of return of 15%, -7%, 13% and 5% in the last 4 months, the average return comes to 6.5%. Thus, we can assume that the average expected rate of return (Re) for this mutual fund in the coming 4 months would be 6.5%.

This number indicates the return rate that we can get if we invest our money in a risk free endeavor, like a fixed deposit scheme. Since the Sharpe Ratio compares our investment with a risk free investment to justify risk, this number is important. If we’re getting a return of 3.5% from an equity mutual fund, then what is the point of taking on so much risk if we can simply get similar returns in a fixed deposit that has virtually no risk?

The standard deviation of a mutual fund is the upward or downward fluctuation of it’s returns in a given period. Suppose a mutual fund has an average rate of return of 12% per annum for the last 10 years. If the standard deviation of the returns was, say 10%, then this means that in the last 10 years the average rate of return for that fund went 10% above and 10% below the average return.The higher the Sharpe Ratio, the better will be the mutual fund. We can look at the Sharpe Ratio of any mutual fund to gauge its risk vs reward. When comparing two mutual funds with similar returns, the fund with the higher Sharpe Ratio is usually the better one.

Let us see how mutual funds are scored using the Sharpe Ratio.

Thus, we can infer that a higher Sharpe Ratio indicates that a mutual fund is likely to give better returns.However, when comparing two funds using the Sharpe Ratio, it is important to ensure that both funds have the same base, that is both of them must be either equity, debt or balanced funds. Let us explain why:For Debt funds: If we compare the Sharpe Ratio of the top 50 debt funds in India, we find that the best fund has a Sharpe Ratio of 5.31, while the worst one has a ratio of 0.51. So far, so good. This looks to be in accordance with the above scoring table.Hybrid Funds: Similarly, if we compare the top 30 hybrid funds, we find that the best fund has a Sharpe Ratio of 1.51 and the worst one had a ratio of 0.02.Equity Funds: When we do the same to equity funds, the best Sharpe Ratio we get is 1.3, while the worst is 0.07.Thus, it is evident that if we look at the Sharpe Ratio as a standalone number for all types of funds, the scoring system doesn’t work very well. Therefore, we must use it to compare similar funds, like 2 equity, or 2 debt-based funds.

The Sharpe Ratio is an important factor when deciding between two funds because it tells us how much risk we should be willing to take for our investment. If the number portrays that we’re not getting the justified return for the risk we’re putting in, then we’re better off investing in less risky endeavours.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.