To calculate the Sharpe Ratio, find the average of the “Portfolio Returns (%)” column using the “=AVERAGE” formula and subtract the risk-free rate out of it. Divide this value by the standard deviation of the portfolio returns, which can be found using the “=STDEV” formula.
3-Year Sharpe Ratio is calculated by dividing the difference between the three-year average returns of the investment and the risk-free rate, by the standard deviation of the investment returns over the past three years.
Usually, any Sharpe ratio greater than 1.0 is considered acceptable to good by investors. A ratio higher than 2.0 is rated as very good. A ratio of 3.0 or higher is considered excellent. A ratio under 1.0 is considered sub-optimal.
(ii) Compute the Sharpe Ratio of your time series of daily PNLt,t = 1,...,n, defined as the following normalized z-score Sharpe = µPNL σPNL × √ 252, where µPNL denotes the average of the daily PNL times series, and σPNL the standard deviation of the daily PNL time series.
To calculate the Sharpe ratio, investors can subtract the risk-free rate of return from the expected rate of return, and then divide that result by the standard deviation (the asset's volatility.)
Sharpe Ratio = (Rx – Rf) / StdDev Rx
Rf = Risk-free rate of return. StdDev Rx = Standard deviation of portfolio return (or, volatility)
Investments having less than 1.00 do not generate higher investor returns. However, investments with Sharpe Ratio between 1.00 to 3.00 are considered great Sharpe Ratio and investments above 3.000 are considered excellent Sharpe Ratio.
Ratios below 1 are considered poor, 1 to 2 are good, 2 to 3 are great, and above 3 are excellent. Sharpe ratio is useful for comparing different investments and assessing whether returns justify the risks.
The Sharpe Ratio can be used to compare two portfolios directly with regard to how much excess return each portfolio achieved for a certain level of risk. Morningstar first calculates a monthly Sharpe Ratio and then annualizes it to put the number in a more useful one-year context.
Like all statistical measures, the Sharpe ratio has limitations: The Sharpe ratio alone does not reveal whether leverage was used to produce the returns. Fund managers can use leverage to boost returns and potentially gain a higher Sharpe ratio.
The returns measured can be of any frequency (i.e. daily, weekly, monthly or annually), as long as they are normally distributed, as the returns can always be annualized. Herein lies the underlying weakness of the ratio – asset returns are not normally distributed.
Downside deviation: This is a measure of the investment's downside volatility or losses. A lower standard deviation implies less risk and consequently a higher Sortino ratio. A higher standard deviation implies more risk and a lower Sortino ratio.
The expected return is calculated by multiplying the probability of each possible return scenario by its corresponding value and then adding up the products. The expected return metric—often denoted as “E(R)”—considers the potential return on an individual security or portfolio and the likelihood of each outcome.
Increasing your Sharpe ratio involves either boosting returns reducing risk, or both. One effective method to achieve this is through sector hedging. Sector hedging involves strategically selecting assets from different sectors to protect against sector-specific risks and to optimize overall portfolio performance.
In another open cell, use the =STDEV function to find the standard deviation of excess return. Finally, calculate the Sharpe ratio by dividing the average by the standard deviation. A negative Sharpe ratio indicates that the investment underperformed the risk-free alternative when risk is taken into account.
A Sharpe ratio less than 1 is considered bad. From 1 to 1.99 is considered adequate/good, from 2 to 2.99 is considered very good, and greater than 3 is considered excellent. The higher a fund's Sharpe ratio, the better its returns have been relative to the amount of investment risk taken.
One of the most popular measures of risk-adjusted returns used by hedge funds is the Sharpe ratio.
Sharpe Ratio Example
The stock has returned an average of 15% annually over the past five years. The risk-free investment is the UK Treasury Bill which has an interest rate of 0.4%. The standard deviation (volatility) of ABC Plc is put at 20%. The Sharpe Ratio calculation = (15% - 0.3%) / 20%= 0.73.
Limitations of Sharpe ratio
Ignores downside risk: The ratio treats all volatility as bad, but not all volatility is negative. It doesn't differentiate between upside (positive) and downside (negative) volatility, which can misrepresent the true risk of an investment.
A beta coefficient of less than 1 means that a stock tends to be less volatile than the overall market. Utility and real estate stocks are two examples of industries that typically have low betas. A beta coefficient of more than 1 means that a stock tends to be more volatile than the overall market.
What is a good standard deviation? While there is no such thing as a good or bad standard deviation, funds with a low standard deviation in the range of 1- 10, may be considered less prone to volatility. This can be mapped to your own risk appetite in order to decide if a fund works for you or not.
Nippon India Small Cap Fund
Among the top performing mutual funds in India, this fund stands out with a remarkable 5-year CAGR of 37.86%, making it one of the best mutual funds to invest in for high-growth opportunities. The Sharpe Ratio of 1.58 signifies balanced risk-adjusted performance.