The Sharpe ratio is used to help investors understand the return of an investment relative to its risk. This is often referred to as the risk-adjusted return.
It was developed by Nobel laureate William F. Sharpe and has been widely used at the pointy end of the funds management industry ever since. So why do you need to know about it?
Definition: The Sharpe ratio looks at the average return above the risk-free rate of return, adjusted for the volatility of returns.
Let’s unpack that a bit…
The average return is the average of the annual returns over a given period. For example, according to SuperRatings, the average annual return of the top 10 balanced funds in the 7 years to June 2019 was close to 10%.
The risk-free rate of return is the average return from government bonds over the same period. In the Australian context, this is generally the Australian Government Bond Index of short and long-term securities. Let’s say the average annual return over the 7 years to June 2019 was a nice round 5%.
Subtracting the risk-free rate from the average annual return allows an investor to better isolate the profits associated with the selection of higher-risk investments. In the example above, the average return above the risk-free rate of return is 5% (10% minus 5%).
Volatility (or the variance of returns) is measured by a statistical measure called the standard deviation. Standard deviation in this instance measures how far a fund’s annual returns deviate from the average return over a given period.
A low standard deviation means annual returns are not spread too far out from the average. A high standard deviation means annual returns are widely dispersed.
Putting it all together
So, what does this look like in practice?
Let’s say two funds report the same average annual return of 10% over 7 years with a risk-free rate of return of 5%. One fund achieves this with relatively consistent actual annual returns of between 8% and 12% over that seven-year period. The other fund’s annual returns fluctuated wildly from a low of 2% one year to a high of 18% the next. The two funds’ long-term performance over 7 years is the same, but one fund got there by taking far less risk.
The lower the standard deviation, the lower the volatility and the higher the Sharpe Ratio.
If that’s just too confusing, it’s enough to know that the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.
Why does it matter?
The upshot is that risk and reward must be evaluated together when you are weighing up investments.
A high level of risk can take rewards away from the investor in the short-term due to higher market volatility. That may not be an issue for younger investors with time to ride out market fluctuations.
However, it’s likely to be of concern for people in or near retirement who need to draw down regular income from super and risk crystallising their market losses by doing so.
The take home message is, that the Sharpe ratio can help you determine the investment choice that will deliver the highest returns while also considering risk.
Unfortunately, it’s not easy to find because super funds don’t routinely disclose the Sharpe ratios of their investment options. The statistically literate with time on their hands might like to google how to calculate the Sharpe ratio to work it out for themselves.
Or if you would like to check the risk-adjusted returns of some top ranked super funds, you can find tables supplied by SuperRatings in the SuperGuide article, Risk and returns: getting the balance right.