Are Your Fund's Returns Worth the Risk?
The Sharpe ratio can help investors compare funds' risk/reward profiles.
Question: I appreciated your series on Modern Portfolio Theory statistics like alpha and beta, which are featured on a fund's Risk & Ratings tab on Morningstar.com. But what about other risk measures, such as the Sharpe ratio?
Answer: In addition to MPT statistics, Morningstar.com offers a range of other volatility measures. One of those is the Sharpe ratio, which is an industry standard that has become a popular metric in quantifying a fund's risk/return profile. But even though the Sharpe ratio holds many practical applications, it's important to understand the extent of its usefulness.
What Is the Sharpe Ratio?
Developed by William F. Sharpe, the Sharpe ratio measures a fund's risk-adjusted returns. The basic idea is to see how much additional return (above and beyond a risk-free asset such as a U.S. Treasury bond) an investor reaps for the additional volatility of holding the asset. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the volatility it has experienced (as measured by standard deviation). Investors can then assess whether a fund's return justifies the risk.