The Sharpe ratio: How to weigh up if a fund manager’s taking on too much risk

Julie Brownlee, Fsp Invest, 05 Sep. 2014

Tags: sharpe ratio, what is the sharpe ratio, calculating the sharpe ratio, assessing fund’s risk, unit trust risk, unit trust performance, performance, unit trusts,

If you’re looking for a unit trust to invest in, chances are you’ll start looking at the performance record first. After all, you’re probably not going to invest in a fund that isn’t performing well.

So what if a fund manager is achieving good returns, but in the process is taking on huge amounts of risk?

That’s where the Sharpe ratio comes in.

Let’s take a closer look at how the Sharpe ratio works and how you can use it…

How to assess a fund manager’s performance

It can be difficult to know if a fund manager is doing a good job.

If you look at the fund manager’s performance, the gains they’ve made don’t necessarily tell you that he’s skilled at his job. He might have just been lucky.

Or the fund manager might be taking on a lot of risk. Taking big risks can lead to high returns, but this increases the chance of the portfolio taking a hit if an investment doesn’t work out.

So what can you do?

How the Sharpe ratio works

William Sharpe created the Sharpe ratio. This measure tries to adjust for the amount of risk a fund manager takes on.

It works by taking the returns a portfolio has made and subtracting the returns you could have made from investing in long-term government bonds. Government bonds are the ‘safest’ investments you can make.

Compare that figure with the risk the portfolio takes on. You can measure this by using the standard deviation. The standard deviation measures how much returns fluctuate around their long-term average.

Calculating the Sharpe ratio

Let’s have a look at an example…

Fund manager Bob’s unit trust returns 20% more than government bonds with risk (or standard deviation) of 10%.

Fund manager Chris’ unit trust returns 20% more than government bonds too. But his risk is 20%.

Bob’s fund has a Sharpe ratio of 2 (20%/10%). Chris’ fund has a Sharpe ratio of 1 (20%/20%).

The higher the Sharpe ratio, the better the fund manager is. He’s producing better returns for the risk he takes on.

So there you have it, how to weigh up if a fund manager is taking on too much risk.

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