Mutual Funds: The Sharpe ratio was developed by Nobel laureate William F. Sharpe in 1966 and has since become one of the most cited metrics in portfolio management.
Suppose you came across a mutual fund scheme that delivered 12 per cent annualised return (Hypothetically). Now this might be tempting because, why not, investors look for funds with high annualised returns. However, this factor, the return garnered from the scheme, though a valid one, must not be the only factor behind deciding your investment. Investors must consider the risk as well. Every investment has a degree of risk associated with it. In fact, it is often a higher risk that has the potential to produce a high return. But is the risk in your investment worth the returns?
Created with AI. Errors are possibleIn other words, how much return are you earning for every unit of risk you take? One commonly used measure to evaluate this risk-adjusted return is the Sharpe Ratio, which indicates how much excess return is generated for each unit of risk undertaken.
Therefore, in case you are planning to redeem a mutual fund. You must check how sharpe ratio can help you decide whether to stay or redeem.
The Sharpe Ratio in mutual funds measures risk-adjusted performance by calculating the excess return generated per unit of volatility. Developed by Nobel laureate William F. Sharpe, it reveals if a fund’s higher returns are genuinely compensating investors for the extra risk and price fluctuations taken.
The Sharpe ratio has three inputs:
Let’s understand each in simple words:
Portfolio Return is the fund’s annualised return over the measurement period – typically three years on most platforms, including Value Research Online.
Risk-Free Rate is the return you could earn without taking any risk – in India, this is usually proxied by the 91-day Treasury bill yield or the overnight repo rate. It represents the baseline: any return above this is the “excess return” the fund manager earned by taking on market risk. The risk-free rate fluctuates; when it is high (as it was in 2023-24 when repo rates were elevated), it is harder for funds to post strong Sharpe ratios because the hurdle is higher, says a report by Value Research.
Standard deviation measures how much a fund’s returns fluctuate around their average. For example, a fund that consistently delivers a 12% return every month would have a standard deviation close to zero, indicating very low volatility. In contrast, a fund that gains 30% in one quarter and loses 15% in the next would exhibit a high standard deviation, reflecting greater variability in returns.
Since standard deviation forms the denominator of the Sharpe Ratio, understanding what it represents and the story it tells about a fund’s volatility is essential before using the Sharpe Ratio to evaluate risk-adjusted performance.
- Annualised return: 14 per cent
- Risk-free rate: 7 per cent
- Standard deviation: 12 per cent
- Sharpe Ratio = (14 per cent − 7 per cent) ÷ 12 per cent = 0.58
This means Fund A generated 0.58 units of excess return for every 1 unit of volatility. Whether 0.58 is “good” depends entirely on the category.
How to interpret Sharpe ratio?
- If the Sharpe ratio is below 0: Poor risk adjustment performance
- If the Sharpe ratio is 0-1: Average
- If the Sharpe ratio is above 1: Good
- If the Sharpe ratio is above 2: Excellent
A higher Sharpe ratio generally indicates better returns for the level of risk taken.
When should investors consider exiting mutual fund based on Sharpe Ratio?
As discussed above, the Sharpe Ratio measures a mutual fund’s risk-adjusted return, i.e., the excess return generated for every unit of risk taken. A higher Sharpe Ratio generally indicates better risk-adjusted performance.
However, the investors should not redeem a mutual fund solely because its Sharpe Ratio has fallen. Instead, an exit may be considered when:
- The fund’s Sharpe Ratio remains consistently lower than its category average and benchmark over a long period (such as 3-5 years).
- The scheme has been underperforming its peers on both returns and risk-adjusted returns.
- The fund’s investment strategy or fund manager has changed significantly.
- The fund no longer aligns with the investor’s financial goals or risk profile.
Key factors to check before redeeming
1. Performance against benchmark
Compare the fund’s returns with its benchmark index over 3-, 5- and 7-year periods.
Check whether the fund consistently ranks in the bottom quartile of its category.
3. Sharpe Ratio versus peers
Compare only with funds in the same category, such as small-cap with small-cap or flexi-cap with flexi-cap funds.
A change in fund management can affect future performance.
Higher costs can reduce investor returns over time.
If the original goal has been achieved or the investor’s risk appetite has changed, redemption may be justified.
(Disclaimer: The above article is meant for informational purposes only, and should not be considered as any investment advice. ET NOW DIGITAL suggests its readers/audience to consult their financial advisors before making any money related decisions.)
