Sharpe Ratio

This is a commonly used measure that calculates the level of a fund’s return over and above the return of a notional risk-free investment, such as cash or government bonds. The difference in returns is then divided by the fund’s standard deviation (volatility). The resulting ratio is an indication of the amount of excess return generated per unit of risk.

Sharpe is useful when comparing similar portfolios or instruments. There is no absolute definition of a “good” or “bad” Sharpe ratio, beyond the thought that a fund with a negative Sharpe would have been better off investing in risk-free government securities. However, in general it is considered that the higher the Sharpe ratio, the better. As the ratio increases, so does the risk-adjusted performance. In effect, when analysing similar investments, the one with the highest Sharpe has achieved more return while taking on no more risk than its fellows — or, conversely, has achieved a similar return with less risk.

If you have a negative ratio this indicates that the Fund actually made less than the risk free amount. As the ratio would effectively become meaningless at this point we use a modified Sharpe Ratio calculation as shown below.