The Sharpe Ratio is a risk-adjusted measure developed by William F. Sharpe. Dr. Sharpe is Professor of Finance at Stanford University Graduate School of Business. He received the Nobel Prize in Economics in 1990.
The Sharpe Ratio is used to measure the mutual funds ability to provide returns in excess of the risk-free rate of return. In other words if we look at the T-bill return for the risk free return, the Sharpe Ratio measures a funds ability to beat the T-bill return.
In technical terms, it is calculated using standard deviation and excess return to determine reward per unit of risk. First, the average monthly return of the 91-day T-bill (over a 36-month period) is subtracted from the fund's average monthly return. The difference in total return represents the fund's excess return beyond that of the 91-day T-bill, a risk-free investment. An mathematic annualized excess return is then calculated by multiplying this monthly return by 12. To show a relationship between excess return and risk, this number is then divided by the standard deviation of the fund's annualized excess returns.
Now that I've lost you, all you need to know is that the higher the Sharpe Ratio, the better the fund's historical risk-adjusted performance. Let's take a look at some examples to help you better understand this number (data provided by Paltrak, Morningstar).
The Maritime Life Money Market has a 10 year Sharpe Ratio of -4.79, a 5-year Sharpe of -6.77 and a 3-year Sharpe of -5.5. Incidentally, these are the worst Sharpe Ratios you will find of any mutual fund. Money markets typically have low Sharpe Ratios because they will never outperform the T-bill rate. Remember that a money market will invest in T-bills but when you subtract the management fee, you will always under perform the gross T-bill rate. The Management fee for the Maritime Life Money Market fund is 2%. It is no wonder why it has the worst Sharpe Ratio of all funds. Basically you would have been far better off putting your money directly in T-bills than buying the Maritime Life Money Market Fund.
On the other hand, the CI Signature Dividend fund has a positive Sharpe for all three time periods: 0.73 for 3 years, 0.26 for 5 years and 0.88 for 10 years. Essentially the Sharpe Ratio is saying that the CI Signature Dividend fund has provided good excess reward relative to the risk of the risk free rate of return. Over the past 3, 5, and 10 years, you were better off buying the CI Dividend Income Fund over buying T-bills or GICs and especially the Maritime Life Money Market Fund.
Sharp ratios are category sensitive
What we have done in the previous example is looked at two different funds from two different asset categories, which is not a fair comparison. The fact is, most equity funds will show a negative Sharpe because of the bear market. You can compare the Sharpe Ratio among funds in the same category but the fact that they are all negative does not necessarily mean all the funds are bad. It is more a reflection that markets were down.
Looking at the fund universe
If we take a look at all the Sharpe Ratios to the end of December 31, 2002, most funds failed the sharp ratio test:
- Average 3 year sharpe ratio for all funds was -0.57
- Average 5 year sharpe ratio for all funds was -0.36
- Average 10 year sharpe ratio for all funds was -0.10
In fact, 75% of all funds had a negative sharpe ratio over 3 and 5 year periods. Negative Sharpe ratios means they fail to outperform the risk free return.
Be careful of Snapshot performance
With any data, including the Sharpe Ratio it is very important to be careful about using snapshot data to create long-term plans.
In fact, back in 1999, the Sharpe Ratio favored equities because of the bull market. Over 3 years, almost 66% of all funds provided excess returns over the risk free rate of return. Over 5 and 10-year periods almost 80% of all funds provided excess returns. All the average Sharpe rations were positive instead of negative. What a difference a few years can make.
With Sharpe Ratios, it is better to look at longer-term data. You can see that the 10 year numbers despite the different snapshots are much more consistent. You can also find why most experts advocate the merits of equities over the long term. Seventy percent to 80% of the funds over the long term will have positive alphas.
Sharpe ratios can be better than just looking at performance because it incorporates the issue of risk. For most investors, the Sharpe makes good intuitive sense because they not only hate to lose money but they often compare the returns to GIC or risk free investing. Many technical analysts will incorporate the Sharpe Ratio when evaluating mutual funds.
The Sharpe Ratio can be a very useful tool when used properly. However, you should never rely too heavily on any single set of data. Be sure to use the Sharpe Ratio in conjunction with other data. Often investors rely too much on performance whether it is the past year or three or five or even ten.
I've always believed in multi-dimensional analysis. The Sharpe Ratio is simply one dimension of many. Look at risk, returns, fees, discipline, etc.