The Sharpe Ratio is a variable that helps us to compare funds of the same type. It is quite a significant factor to take into account, although it is always advisable to use it in combination with others. To measure the quality of a fund, it is important to take into account its profitability, as well as the risk factor. It cannot be said that one fund is better than another because it has been more profitable over a given period of time. You have to measure the relationship between the profitability and risk factors, which is exactly what the Sharpe Ratio does.
This ratio has been extended in recent years, since it is a very simple way to evaluate the performance of investment funds. The riskier an investment, the higher the expected return. With this ratio, we can buy portfolios of different risks and see which has been more successful and has obtained additional profitability by investing in riskier assets.
How is it calculated?
It is calculated after deducting the return on a risk-free asset, which is usually the yield on Treasury Notes or an index such as Euribor. The way to calculate it is by dividing the profitability of an investment fund minus the risk-free interest rate by the volatility or what we call the standard deviation over a certain period of time:
Sharpe Ratio = Fund Profitability - Risk-free Interest Rate/Standard Deviation.
A higher Sharpe Ratio means better risk management, so the fund return offsets the risk incurred. Sharpe ratios above 1 are considered to be very positive, as they offer higher returns relative to the risk that the fund has taken on. Therefore, it numerically measures the relationship between profitability and historical volatility in an investment fund. The higher the volatility, the higher the risk, since the probability that the fund will have a negative return increases. Simply put: the more a fund oscillates, the greater its volatility.
The higher this ratio, the more desirable the investment will be, as risk will be offset by volatility. When a Sharpe Ratio is negative, it indicates that your return is less than the risk-free return. The higher this ratio, the better.