Sharpe Ratio


DEFINITION of 'Sharpe Ratio'

The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be isolated. One intuition of this calculation is that a portfolio engaging in “zero risk” investment, such as the purchase of U.S. Treasury bills (for which the expected return is the risk-free rate), has a Sharpe ratio of exactly zero. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.


Loading the player...

BREAKING DOWN 'Sharpe Ratio'

The Sharpe ratio has become the most widely used method for calculating risk-adjusted return; however, it can be inaccurate when applied to portfolios or assets that do not have a normal distribution of expected returns. Many assets have a high degree of kurtosis ('fat tails') or negative skewness. The Sharp ratio also tends to fail when analyzing portfolios with significant non-linear risks, such as options or warrants. Alternative risk-adjusted return methodologies have emerged over the years, including the Sortino Ratio, Return Over Maximum Drawdown (RoMaD), and the Treynor Ratio.

Modern Portfolio Theory states that adding assets to a diversified portfolio that have correlations of less than one with each other can decrease portfolio risk without sacrificing return. Such diversification will serve to increase the Sharpe ratio of a portfolio.

Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return

Sharpe Ratio

The ex-ante Sharpe ratio formula uses expected returns while the ex-post Sharpe ratio uses realized returns.

Applications of the Sharpe Ratio

The Sharpe ratio is often used to compare the change in a portfolio's overall risk-return characteristics when a new asset or asset class is added to it. For example, a portfolio manager is considering adding a hedge fund allocation to his existing 50/50 investment portfolio of stocks which has a Sharpe ratio of 0.67. If the new portfolio's allocation is 40/40/20 stocks, bonds and a diversified hedge fund allocation (perhaps a fund of funds), the Sharpe ratio increases to 0.87. This indicates that although the hedge fund investment is risky as a standalone exposure, it actually improves the risk-return characteristic of the combined portfolio, and thus adds a diversification benefit. If the addition of the new investment lowered the Sharpe ratio, it should not be added to the portfolio.

The Sharpe ratio can also help explain whether a portfolio's excess returns are due to smart investment decisions or a result of too much risk. Although one portfolio or fund can enjoy higher returns than its peers, it is only a good investment if those higher returns do not come with an excess of additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

Criticisms and Alternatives

The Sharpe ratio uses the standard deviation of returns in the denominator as its proxy of total portfolio risk, which assumes that returns are normally distributed. Evidence has shown that returns on financial assets tend to deviate from a normal distribution and may make interpretations of the Sharpe ratio misleading.

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility and uses the semivariance in the denominator. The Treynor ratio uses systematic risk, or beta (β) instead of standard deviation as the risk measure in the denominator.

The Sharpe ratio can also be "gamed" by hedge funds or portfolio managers seeking to boost their apparent risk-adjusted returns history. This can be done by:

  • Lengthening the measurement interval: This will result in a lower estimate of volatility. For example, the annualized standard deviation of daily returns is generally higher than of weekly returns, which is, in turn, higher than of monthly returns.
  • Compounding the monthly returns but calculating the standard deviation from the not compounded monthly returns.
  • Writing out-of-the-money puts and calls on a portfolio: This strategy can potentially increase the return by collecting the option premium without paying off for several years. Strategies that involve taking on default risk, liquidity risk, or other forms of catastrophe risk have the same ability to report an upwardly biased Sharpe ratio. (An example is the Sharpe ratios of market-neutral hedge funds before and after the 1998 liquidity crisis.)
  • Smoothing of returns: Using certain derivative structures, infrequent marking to market of illiquid assets, or using pricing models that understate monthly gains or losses can reduce reported volatility.
  • Eliminating extreme returns: Because such returns increase the reported standard deviation of a hedge fund, a manager may chose to attempt to eliminate the best and the worst monthly returns each year to reduce the standard deviation.
  1. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  2. Roy's Safety-First Criterion - ...

    An approach to investment decisions that sets a minimum required ...
  3. Downside Deviation

    A measure of downside risk that focuses on returns that fall ...
  4. Modified Sharpe Ratio

    A ratio used to calculate the risk-adjusted performance of an ...
  5. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned ...
  6. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with ...
Related Articles
  1. Mutual Funds & ETFs

    The Basics of How Mutual Funds Are Rated

    Learn how the major rating agencies assign mutual fund ratings. Understand what these ratings measure and how they are different from each other.
  2. Mutual Funds & ETFs

    3 Mutual Funds That Hold Facebook Stock

    Explore detailed analysis of three mutual funds that include common stock of social media giant Facebook, Inc. in their top holdings.
  3. Mutual Funds & ETFs

    Top 4 Diversified Emerging Market Mutual Funds

    Explore analysis of the top diversified emerging market mutual funds, and learn about their modern portfolio theory statistics, characteristics and suitability.
  4. Mutual Funds & ETFs

    Top 3 Africa ETFs

    Explore detailed analysis of the top three exchange-traded funds that track the African companies, and learn the type of investors these ETFs and suitable for.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI India

    Learn about the iShares MSCI India exchange-traded fund, which invests in equities of Indian companies and is suitable for risk-tolerant investors.
  6. Mutual Funds & ETFs

    ETF Analysis: First Trust Dow Jones Global Sel Div

    Find out about the First Trust Dow Jones Global Select Dividend Index Fund, and learn detailed information about characteristics and suitability of the fund.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares US Healthcare

    Learn about the iShares U.S. Healthcare exchange-traded fund, which invests in a wide range of health care providers, hospitals and home care facilities.
  8. Mutual Funds & ETFs

    ETF Analysis: PowerShares KBW Bank

    Consider an examination and analysis of the PowerShares KBW Bank Portfolio ETF, considered one of the primary financial sector ETFs.
  9. Mutual Funds & ETFs

    ETF Analysis: Direxion Daily Financial Bull 3X

    Obtain a thorough review and analysis of the Direxion Daily Financial Bull 3X fund, a leveraged ETF that tracks the performance of the financial sector.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Europe Financials

    Learn about the iShares MSCI Europe Financials fund, which invests in numerous European financial industries, such as banks, insurance and real estate.
  1. How do I use smart beta funds to create a diversified portfolio?

    Smart beta funds may use rules-based strategies to allocate investments across different asset classes and ensure portfolio ... Read Full Answer >>
  2. What are the advantages and disadvantages of zero-based budgeting in accounting?

    The main controversy over the use of the information ratio is that it is an ex-post measurement often used to predict the ... Read Full Answer >>
  3. What metrics should I use to evaluate the risk return tradeoff for a mutual fund?

    One of the principles of investing is the risk-return tradeoff, defined as the correlation between the level of risk and ... Read Full Answer >>
  4. What should you take into consideration when choosing a portfolio management service?

    Hiring a portfolio management service or a portfolio manager should be a logical decision based on topics of consideration ... Read Full Answer >>
  5. What is the difference between a Sharpe ratio and a Traynor ratio?

    The Sharpe ratio and the Treynor ratio (both named for their creators, William Sharpe and Jack Treynor), are two ratios utilized ... Read Full Answer >>
  6. What is the difference between a Sharpe ratio and a Sortino ratio

    The Sharpe ratio and the Sortino ratio are both risk-adjusted evaluations of return on investment. The Sortino ratio is a ... Read Full Answer >>
  7. What is the difference between a sharpe ratio and an information ratio?

    The Sharpe ratio and the information ratio are both tools used to evaluate the risk-adjusted rate of return of an investment ... Read Full Answer >>
  8. What is a good Sharpe ratio?

    The Sharpe ratio is a well-known and well-reputed measure of risk-adjusted return on investment, developed by William Sharpe. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  4. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  5. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  6. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!