Are Your Fund's Returns Worth the Risk?

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.

To that end, the Sharpe ratio is a useful measure because a fund that outperforms its peers might look less enticing if those returns came with a lot of additional volatility. A fund that can achieve a 6% return with mild volatility is likely a better bet than a fund that can attain a 7% return but only with a lot of ups and downs.

How Is It Calculated?
As long as a fund has at least 36 months' worth of data, Morningstar calculates a fund's Sharpe ratio for the one-, three-, five-, and 10-year periods. It is calculated on a monthly basis by dividing a fund's monthly excess returns (the portfolio return minus the risk-free return of a benchmark that Morningstar chooses based on the portfolio's domicile) by its monthly standard deviation. Note that both standard deviation and the Sharpe ratio are ultimately annualized figures. Click here to learn more about how Morningstar calculates the Sharpe ratio and standard deviation.

The higher a fund's standard deviation, the higher the fund's returns need to be to earn a high Sharpe ratio. Conversely, funds with lower standard deviations can sport a higher Sharpe ratio if they have consistently decent returns. Keep in mind that even though a higher Sharpe ratio indicates a better historical risk-adjusted performance, this doesn't necessarily translate to a lower-volatility fund. A higher Sharpe ratio just means that the fund's risk/return relationship is more proportional or optimal.

How Can It Be Used?
The Sharpe ratio helps to make a more direct comparison of how much risk two funds each had to bear to earn excess return over the risk-free rate. And because the Sharpe ratio is risk-adjusted (standard deviation is a standardized measure and calculated the same way for all funds), it levels out the playing field. This allows investors to compare the Sharpe ratios of funds that employ different strategies--growth versus value or leveraged versus unleveraged strategies, for example.

Although there's no denying that the Sharpe ratio is useful, the metric is not without shortcomings. For starters, the Sharpe ratio (like MPT statistics) is calculated based on historical returns, which, as we are often reminded, are not predictors of future results. This is particularly true if a fund's management or mandate has changed, which could result in a different strategy and profile going forward. Another drawback is the fact that Sharpe ratio is a raw number. Although we know that a higher Sharpe ratio is favorable, it's hard to recognize whether a Sharpe ratio is good or bad, high or low, when it's analyzed in isolation. However, comparing it with the Sharpe ratio for a similar fund, an index, or a category allows investors to put a fund's Sharpe ratio into context.

Negative Sharpe ratios are also problematic, because, counterintuitively, when returns are negative, greater risk results in a higher Sharpe ratio. In addition, some would argue that a negative Sharpe ratio isn't meaningful because the ratio is meant to help put an investment's excess returns into context, and when a fund has negative returns, it is obviously not beating the risk-free rate. Additionally, the use of standard deviation in the Sharpe ratio formula imposes its own set of limitations because standard deviation assumes an approximately symmetric return distribution. For funds with asymmetric returns, standard deviation can be a problematic measure of volatility.

Finally, it's always important to employ Sharpe ratios within the context of your own risk profile. If you have a long investing time horizon, near-term Sharpe ratio figures won't be as relevant. As previously noted, keep in mind that it's possible that a riskier fund could have a higher Sharpe ratio than a less exciting but steady-Eddie offering if the former fund's returns are high enough. Risk-averse investors might still choose the steady-Eddie fund because, despite the promise of higher returns, they also value a smoother ride.