When just about all equity funds have clocked 100 per cent growth in net

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asset values (NAVs) since March, it is important for investors to understand whether a portfolio's returns are due to smart investment decisions or a result of excess risk! A ratio — known as Sharpe ratio — developed by Nobel Prize-winner William Sharpe, shows how to find glean this information. The greater a fund portfolio's Sharpe ratio, the better its risk-adjusted performance has been, experts say. This measurement is very useful because although, one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk.

How does one calculate this ratio? Sharpe ratio is one-single number, which represents the trade off between risks and returns. When things go wrong, high risks can extract a heavier loss from investments in a fund. Risk in this case is taken to be the fund's standard deviation. Standard deviation is a measure of the dispersion of a set of data from its average. In case of a fund, the standard deviation represents the total risk experienced by a fund and hence, the Sharpe ratio reflects the returns generated by undertaking all possible risks.

According to Krishnan Sitaraman, director, Crisil FundServices, investors should pay attention to the risk taken by the fund managers to bag whopping returns. "Measuring risk-adjusted performance is important.” Equity-focused funds will have higher Sharpe ratios than liquid funds, which invest in debt instruments, he added.

For investors, the catch lies in comparing two funds that have similar returns but slightly different Sharpe ratios. For example, if manager A generates a return of 100 per cent, while manager B generates a return of 95 per cent, it would appear that manager A is a better performer. However, if manager produced 100 per cent returns taking much larger risks than manager B, it may actually be the case that manager B has a better ‘risk-adjusted’ return. “The ratio lets us compare performances across fund houses because the Sharpe ratio is a standardised figure. A high Sharpe ratio is always better than a low ratio,” says Sweta Rayal, research analyst, Icra Online.

Measures such as Sharpe ratio provide an unbiased look into a fund's performance. "This is because this ratio is based solely on a quantitative measure. However, this does not account for any risks inherent in a fund’s portfolio. A quantitative tool like Sharpe ratio should be used along with information on the nature of the fund’s strategies, its fund management style and risk inherent in the portfolio," says Dhirendra Kumar of ValueResearch, a Delhi-based mutual fund tracking firm.