How to use the Sharpe ratio to unearth a good unit trust to invest in

Julie Brownlee, Fsp Invest, 02 Feb. 2015

Tags: unit trusts, sharpe ratio, unit trust, unit trust fund, investing in funds, weighing up fund performance, fund manager performance,



Picking a unit trust to invest in isn’t an easy task. There are so many funds out there.

Once you decide what type of fund you want to invest in, how can you work out if the fund manager is any good?

You can look at the Sharpe ratio.

So what is the Sharpe ratio? And how can you use it?

Read on to find out…



Picking a fund manager


It can be hard to know whether a fund manager is any good. When investing in unit trusts, you want to hone in on fund managers that are performing well.

If a fund manager is doing well, is it because he’s really good at picking stocks for the fund or is it all down to luck? Or is the fund manager taking on big risks to get decent performance?

There’s a relationship between risk and return.

If a fund manager opts to take on higher risk, there’s a chance of higher return. And if a fund manager is doing this, they might not be very skilled a stock picking after all.

This is where the Sharpe ratio comes in…


What is the Sharpe ratio?


William Sharpe is a Professor of finance at Stanford University. In the 1960s he set about finding a way to evaluate the performance of a portfolio.

He did this by formulating a calculation to measure a portfolio’s returns less the returns from a risk-free asset, like long-term government bonds.

Professor Sharpe compared a portfolio’s returns with the risk taken. He used standard deviation to measure risk. In other words, he looked at how much returns bounced around their long-term average.


The Sharpe ratio in action


Let’s say fund manager A has a fund which returns 20% more than government bonds, with a standard deviation of 10%.

Fund manager B has a fund which also returns 20% more than government bonds, but has a standard deviation of 20%.

This means fund manager A has a Sharpe ratio of 2 (20%/10%) and fund manager B has a Sharpe ratio of 1 (20%/20%).

The higher the Sharpe ratio, the more skill the fund manager is displaying. In other words, the fund manager is getting better returns for the risk they take on. This makes fund manager A the more skilled.

Some fund fact sheets detail Sharpe ratios along with research into the performance of funds.

So there you have it. How to use the Sharpe ratio to unearth a good unit trust to invest in.

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