Course 205: Gauging Risk and Return Together, Part 1
The Sharpe Ratio Defined
In this course
1 Introduction
2 Alpha Defined
3 How to Use Alpha
4 The Sharpe Ratio Defined
5 How to Use the Sharpe Ratio

The Sharpe ratio uses standard deviation to measure a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories.

Developed by its namesake, Nobel Laureate William Sharpe, this measure quantifies a fund's return in excess of our proxy for a risk-free, guaranteed investment (the 90-day Treasury bill) relative to its standard deviation. To calculate a fund's Sharpe ratio, first subtract the return of the 90-day Treasury bill from the fund's returns, then divide that figure by the fund's standard deviation. If a fund produced a return of 25% with a standard deviation of 10 and the T-bill returned 5%, the fund's Sharpe ratio would be 2.0: (25-5)/10.

The higher a fund's Sharpe ratio, the better its returns have been relative to the amount of investment risk it has taken. For example, both State Street Global Research SSGRX and Morgan Stanley Inst. European Real Estate MSUAX have enjoyed heady three-year returns of 23.9% through August 2004. But Morgan Stanley sports a Sharpe ratio of 1.09 versus State Street's 0.74, indicating that Morgan Stanley took on less risk to achieve the same return.

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..

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