The Sharpe Ratio Defined

The Sharpe ratio uses standard deviation to measure a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories.

How it works

Developed by its namesake, Nobel Laureate William Sharpe, this measure quantifies a fund's return in excess of our proxy for a risk-free, guaranteed investment (the 90-day Treasury bill) relative to its standard deviation. To calculate a fund's Sharpe ratio, first subtract the return of the 90-day Treasury bill from the fund's returns, then divide that figure by the fund's standard deviation. If a fund produced a return of 25% with a standard deviation of 10 and the T-bill returned 5%, the fund's Sharpe ratio would be 2.0: (2525)410.

What the number means

The higher a fund's Sharpe ratio, the better its returns have been relative to the amount of investment risk it has taken. For example, both Fund X and Fund Y enjoyed heady three-year returns of 23.9% during that stretch. But Fund Y sports a Sharpe ratio of 1.09 versus Fund X's 0.74, indicating that Fund Y took on less risk to achieve the same return.

The higher a fund's standard deviation, the larger the denominator of the Sharpe ratio equation; therefore, the fund needs to generate high returns to earn a high Sharpe ratio. Conversely, funds with modest standard deviations can carry high Sharpe ratios if they generate good returns.