A lot has been written about the simple Sharpe Ratio (this is my 3rd blog entry about it).
The Sharpe Ratio is popular because it gives investors a way to view a fund or portfolio’s return taking Volatility and Risk out of the picture.
When evaluating the Sharpe Ratio keep these things in mind:
- The Higher the Sharpe Ratio, the better the risk:reward.
- The Sharpe Ratio uses Standard Deviation as a measurement of volatility (Risk) and your Excess Return as a measurement of your Reward.
- The Risk Free Rate determines the return that you could get with 0 risk. This is traditionally the T-Bill
- If the Sharpe Ratio is Negative, the Fund Return is lower than the Risk Free Rate (not good)
- An annual Sharpe Ratio of 1 or better is considered good
The main cause of confusion in calculating your sharpe ratio is determining whether to use monthly or annual numbers. If you use monthly returns but then an annual RFR then your numbers will be off.
This step by step guide will help you get the correct monthly sharpe ratio.
The formula for the Sharpe Ratio is:
Excess Return / Standard Deviation
Determining the Excess return is simply subtracting the monthly risk free rate from the monthly average return:
Monthly Average Return - the Monthly Risk Free Rate
It is important to differentiate between the Monthly Risk Free Rate and the Annual Risk Free Rate.
If you want to get the Monthly RFR from the Annual you would use this formula:
(Annual RFR + 1)^(1/12) - 1
So a Annual RFR of 4.5% would turn into
(.045+1) ^ (1/12) - 1 = .00367 = .37%
If your Average Monthly return was 1%:
1% - .37% = .63%
If your Monthly Standard Deviation is 5.85% (annualized to 20.26%)
Your Sharpe Ratio would be:
.63% / 5.85% = 0.10768
Sharpe Ratio should never be represented as a percentage.
To annualize the Sharpe Ratio simply multiply it by the Square Root of 12.
0.10768 * sqrt(12) = .37%