Named after its founder Nobel Laureate William Sharpe, the Sharpe Ratio helps study the risk-adjusted performance of a mutual fund. Technically, the ratio is defined as the excess returns of a scheme (over a risk-free rate) divided by the standard deviation of the scheme’s returns for a given period.
In other words, the Sharpe Ratio uses standard deviation to measure a fund's risk-adjusted returns.
The higher the deviation, the higher the risk and hence, lower the Sharpe ratio. Simply put, this measure determines how the return of the scheme has compensated an investor for the risks it has taken. The higher a fund’s Sharpe Ratio, the better the fund’s returns relative to the risk taken. Because it uses standard deviation, the Sharpe Ratio can be used to compare risk-adjusted returns across all fund categories.
The risk-free rate can be the 91 or 364-day Treasury-Bill issued by the government.
Since the Sharpe Ratio quantifies a fund's return in excess of the proxy for a risk-free, guaranteed investment (let’s take it as the the 90-day Treasury bill) relative to its standard deviation, to calculate it, first subtract the return of the 90-day Treasury bill from the fund's returns, then divide that figure by the fund's standard deviation. If a fund produced a return of 25% with a standard deviation of 10 and the T-bill returned 5%, the fund's Sharpe Ratio would be 2: (25-5)/10.
Let’s look at it in a more illustrative way.
Fund Y returns 10% in a year while Fund Z returns 8%. With a risk free rate of 4%, the standard deviation of Y and Z is 8% and 4%, respectively. Hence their respective Sharpe Ratios are 0.75 and 1.
Thus, contrary to the initial inference that Fund Y was the superior performer (based on returns), Fund Z turns in a better performance on the risk-adjusted front.
Or let’s say Fund X and Fund Y have enjoyed heady 3-year returns of 23%. But Fund X sports a Sharpe Ratio of 1.09 versus Fund Y’s 0.74, indicating that Fund X took on less risk to achieve the same return.
The higher a fund's standard deviation, the higher the fund's returns need to be to earn a high Sharpe ratio. Conversely, funds with lower standard deviations can sport a higher Sharpe Ratio if they have consistently decent returns.
But do note that this measure by itself provides little meaningful information. Of course, the higher the Sharpe Ratio the better. But given no other information, you can't tell whether a Sharpe Ratio of 1.5 is good or bad. Only when you compare one fund's Sharpe Ratio with that of another fund (or group of funds) do you get a feel for its risk-adjusted return relative to other funds. Using this measure makes sense when comparing schemes; the one with a higher Sharpe Ratio gives better returns for the same level of risk or the same returns with a lower level of risk. However, it is important to note that the schemes being compared should be of the same category. Comparing the Sharpe Ratio of a large-cap scheme with a sector scheme is fallacious as both funds are dissimilar.
As a rule of thumb, a ratio of 1 and above is good, 2 and above is very good and 3 and above is excellent.
It is advisable to look at this ratio over several periods to assess how the scheme has fared in different market cycles.
Also keep in mind that even though a higher Sharpe Ratio indicates a better historical risk-adjusted performance, this doesn't necessarily translate to a lower-volatility fund. A higher Sharpe ratio just means that the fund's risk/return relationship is more proportional or optimal.