Portfolio Performance

Measuring Portfolio Returns using the Sharpe Ratio

Introduction and history

The Sharpe ratio (also called Sharpe's measure), was developed by William F. Sharpe in

1966. Sharpe ratio has been one of the most referenced risk/return measures used in finance, and

much of this popularity can be attributed to its simplicity. The ratio's credibility was boosted

further when Professor Sharpe won a Nobel Memorial Prize in Economic Sciences in 1990 for

his work on the capital asset pricing model (CAPM).

Using the Sharpe Ratio

The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the

performance of a portfolio. The ratio helps to make the performance of one portfolio comparable

to that of another portfolio by making an adjustment for risk.

Most people with a financial background can quickly comprehend how the Sharpe ratio is

calculated and what it represents. The ratio describes how much excess return you are receiving

for the extra volatility that you endure for holding a riskier asset. Remember, you always need to

be properly compensated for the additional risk you take for not holding a risk-free asset.

The Sharpe ratio is the ratio of a portfolio's total return minus the risk-free rate divided by the

standard deviation of the portfolio, which is a measure of its risk. The Sharpe ratio is simply the

risk premium per unit of risk, which is quantified by the standard deviation of the portfolio.

Risk Premium = Total Portfolio Return – Risk-free Rate

Sharpe Ratio = Risk Premium / Standard Deviation of Portfolio Return

The risk-free rate is subtracted from the portfolio return because a risk-free asset, often

exemplified by the T-bill, has no risk premium since the return of a risk-free asset is certain.

Therefore, if a portfolio's return is equal to or less than the risk-free rate, then it makes no sense

to invest in the risky assets.

Hence, the Sharpe ratio measures the performance of the portfolio compared to the risk taken—

the higher the Sharpe ratio, the better the performance and the greater the profits for taking on

additional risk.

Example—Calculating the Sharpe Ratio

If a fund has a return of 12% and a standard deviation of 15%, and if the risk-free rate is

2%, then what is its Sharpe ratio?

Solution:

Sharpe Ratio = (12% – 2%) / 15% = 10% / 15% = 66.7% (rounded)

Summary

Sharpe ratio (Sx) = (Rx –Rf)/stdDeVx Where;

x –investment

Rx- average return of x

Rf –risk free rate

Std/DeVx- Standard deviation of x

 Return (rx)

The returns measured can be of any frequency (i.e. daily, weekly, monthly or annually), as long

as they are normally distributed, as the returns can always be annualized. Herein lies the

underlying weakness of the ratio – not all asset returns are normally distributed.

Risk-Free Rate of Return (rf )

The risk-free rate of return is used to see if you are being properly compensated for the

additional risk you are taking on with the risky asset. Traditionally, the risk-free rate of return is

the shortest-dated government T-bill (i.e. U.S. T-Bill). While this type of security will have the

least volatility, some would argue that the risk-free security used should match the duration of

the investment it is being compared against.

Standard Deviation (StdDev(x))

Now that we have calculated the excess return from subtracting the risk-free rate of return from

the return of the risky asset, we need to divide this by the standard deviation of the risky asset

being measured. As mentioned above, the higher the number, the better the investment looks

from a risk/return perspective.

Example 2

If manager A generates a return of 15% while manager B generates a return of 12%, the risk

free-rate is 5%, and manager A's portfolio has a standard deviation of 8%, while manager B's

portfolio has a standard deviation of 5%.

Solution
The Sharpe ratio for manager A would be (15% – 5%) / 8% = 10% / 8% = 1.25% while manager

B's ratio would be (12% – 5%) / 5% = 7% / 5% = 1.4% , which is better than manager A. Based

on these calculations, manager B was able to generate a higher return on a risk-adjusted basis.