What is the Sharpe Ratio in Mutual Funds? Calculation and Impact Explained

When it comes to making an investment, everyone wants an option that can yield better returns. In the last few years, mutual funds have become a popular choice among investors with diverse requirements. The main reason behind this is their higher ROI and portfolio diversification capabilities. But given the number of options available in the market, choosing a mutual fund has also become a task. There are several factors that you need to take into consideration, and the risk associated with a mutual fund scheme is one of them.

Table of content

What is the Sharpe Ratio?
How to Calculate the Sharpe Ratio
What is a Good Sharpe Ratio?
Importance of Sharpe Ratio in Mutual Fund Investments

Now the question arises – how to determine the risk a particular mutual fund comes with? Well, here is the answer to this commonly asked question – always check the Sharpe Ratio of a mutual fund before making a selection.

What is the Sharpe Ratio?

In 1966, a famous American economist, William Sharpe, coined the term Sharpe Ratio. This is a financial metric used to evaluate the risk-adjusted performance of an investment. In simple words, the Sharpe Ratio can be defined as the total amount of return you can expect for each unit of risk you take. Generally, a higher Sharpe ratio is considered better, as it indicates higher chances of making a good profit with a lesser amount of risk.

How to Calculate the Sharpe Ratio?

The process of calculating the Sharpe Ratio is very simple. You can get this value using the following formula:

Sharpe Ratio = (R(p)-R(f))/SD

R(p): This is the value of the historical return of the mutual fund for which you are calculating the Sharpe ratio. Although any time period can be used to get this value, it is always best to go for a longer duration.
R(f): This is the value of the risk-free return associated with that mutual fund scheme.
SD: This is the standard deviation of the fund's return. This value shows fluctuations in the fund's performance over time.

What is a Good Sharpe Ratio?

The Sharpe Ratio measures how much return a mutual fund can generate as compared to the risk associated with it. Here are what different values of the Sharpe Ratio mean:

Above 1.0: Good
Above 2.0: Very Good
Above 3.0: Excellent

Importance of Sharpe Ratio in Mutual Fund Investments

The Sharpe Ratio is one of the key factors that are taken into consideration while choosing a mutual fund. It helps an investor understand the amount of risk he/she is taking and also gives an approximate idea of the expected returns. The Sharpe Ratio also helps in comparing various mutual funds. You can compare the performance of different mutual fund schemes within the same category and identify which one will generate higher returns. This way, you can determine if a particular mutual fund scheme aligns with your financial goals and risk profile or not.

Apart from this, the Sharpe Ratio can also help you compare the risk-adjusted performance of a mutual fund scheme to its benchmark. Using this value, you’ll be able to understand if that particular fund has underperformed or outperformed in the past.

Limitations

By showing how much risk is involved in a mutual fund scheme, the Sharpe ratio can make things a lot easier for investors. However, like any other metric, the Sharpe Ratio also has certain limitations. Some of these are:

The Sharpe ratio of a fund does not give an idea about the portfolio risk.
While calculating the Sharpe Ratio, a normal return dispersion is taken into consideration. But in reality, each fund has its own pattern according to which returns are dispersed.
The Sharpe ratio can only reflect risk-adjusted returns while comparing multiple mutual fund schemes.

For those who are just starting out with mutual fund investments and have limited understanding of market trends, the Sharpe Ratio can prove to be very useful. This can help you understand if a particular mutual fund scheme is suitable as per your risk appetite or not. However, it is also important to keep in mind that the Sharpe Ratio cannot be the only factor you consider while making a decision. At Muthoot Finance, we offer various mutual fund schemes that offer high returns. You can explore all the options online and make a selection. We also have a dedicated team of finance experts who can help you make the right decision. For more information, you can either reach out to us online or visit your nearest Muthoot Finance branch.