Interpreting the Sharpe ratio

When interpreting the value of a hedge fund or other investment’s Sharpe ratio, it is important to understand the formula behind the number. In this discussion, we will take a closer look at the basic analytics behind the Sharpe ratio, and then consider the effect that each component may have on the calculation.

Although the Sharpe ratio is frequently presented in simplified form as a single value, understanding it’s unsolved construction may provide additional insight. The equation is as follows:

According to the formula, the numerator is the difference between an investment’s average monthly performance and the rate of return of return of a risk-free alternative investment. With this description in mind, it is important to note the placement of these components in the equation. When all other things are held constant, an increase in the excess returns of an investment will result in a greater Sharpe ratio.

The opposite is true for the denominator, which is monthly standard deviation, or a measurement of the investment’s volatility.  Hence, the higher the standard deviation of an investment, the lower its Sharpe Ratio.

The implication of this arrangement is that the Sharpe ratio is a measurement of return per unit of risk. It is for this reason that an investment’s Sharpe ratio is generally considered to be improving as its value increases, and vice versa.