Sharpe ratio

Investors want attractive returns, but they also want to feel comfortable with how those returns are earned. The Sharpe ratio is one way to connect those goals. It does not just look at how much an investment earns. It also looks at how bumpy the ride is along the way.

In this article, Wealth Professional Canada will shed light on what the Sharpe ratio is, how it is calculated, and what counts as "good" or "bad". Want to read the latest Sharpe ratio news? Scroll to the bottom to explore all that we've published!

What is the Sharpe ratio?

The Sharpe ratio is a way to measure how well an investment compensates your clients for the volatility they accept. It takes the return of the investment and subtracts the return of a risk-free asset.

Then, it divides that result by the standard deviation of the investment's returns. You can think of it as an excess return per unit of risk.

Watch this video to learn more about this measure:

Blue-chip stocks tend to have high Sharpe ratios due to risk-adjusted returns.

The Sharpe ratio formula and its parts

Here is the general formula for a portfolio:

Portfolio return is the average annual return that the portfolio has delivered over the period you are studying. This can be a historical result or a projected figure, as long as you are consistent in how you use it.

The risk-free rate is usually taken from a very secure asset. In Canada, a common choice is a Government of Canada bond. For example, if you are reviewing a five-year holding period, you might use the yield on a five-year Government of Canada bond as your risk-free benchmark.

Standard deviation is a mathematical measure that shows how much returns move around their average over time. A higher standard deviation means the return path is more volatile. That means more dramatic swings above and below the average.

In a strict application of the Sharpe ratio, the standard deviation should be calculated on excess returns. That means you subtract the risk-free rate from each period's portfolio return first, then calculate the standard deviation of those differences.

Many investors overlook this point and use the volatility of total returns instead, which can distort the ratio. In plain language, the Sharpe ratio looks at how much return above the safe alternative your clients received for each step of volatility along the way.

How financial advisors can use the Sharpe ratio

As a financial advisor, you can use the Sharpe ratio to compare portfolios, funds, and strategies that serve similar roles for your clients. It is especially common when you look at stocks, exchange traded funds (ETFs), and mutual funds.

One advantage of the ratio is that it looks beyond absolute return. A fund with a high raw return can have very large swings along the way.

Another fund with a slightly lower raw return but much lower volatility could end up with a higher Sharpe ratio. For your clients, the second fund can feel more comfortable, especially if they are sensitive to market swings.

This is why the Sharpe ratio is often described as a measure of risk-adjusted performance. You can use that insight to sort through funds that appear similar when you look only at annual returns.

A portfolio that looks strong on a simple return chart can look weak when you compare Sharpe ratios with its peers.

What is a good Sharpe ratio?

When you introduce the Sharpe ratio to your clients, one of the first questions you will hear is, "What is a good number?" The simple answer is that higher is better, but there is a helpful grading system you can use. Here is how to interpret Sharpe ratios for funds you are reviewing for your clients:

A Sharpe ratio below one suggests that the return that your clients are getting does not really justify the amount of volatility they are taking on. A portfolio in that zone can still be profitable in dollar terms, but once you adjust for the ups and downs, the result is not very appealing.

On the other hand, anything above three is rare and is often described as excellent. A ratio that high suggests that the portfolio has produced a very strong return relative to its volatility. When you see a number like this, it can be tempting to assume that the manager is very skilled.

Is a 0.7 Sharpe ratio good?

With those ranges in mind, a Sharpe ratio of 0.7 falls below one, so it sits in the "bad" zone in this grading system.

However, that does not always mean that the investment is a complete failure. It does mean that given the fluctuations in return, the extra reward over the risk-free rate has not been very strong.

How to interpret a 0.7 Sharpe ratio

Suppose a fund has grown in value over the past few years, and your clients see positive annual returns. If the standard deviation of its returns is high and the excess return above the risk-free rate is modest, the Sharpe ratio can still come out below one.

In simple terms, your clients have had a bumpy ride without enough extra gain to make that bumpiness feel worthwhile. A ratio around 0.7 can raise questions such as:

• Is this strategy taking on more volatility than your clients are comfortable with?
• Are there other funds or portfolios with similar return levels but less volatility, and therefore a higher Sharpe ratio?
• Has the number been improving or weakening as market conditions change?

Instead of looking at 0.7 in isolation, it helps to compare it with other options that serve the same role in your clients' portfolios. If another fund in the same category has a Sharpe ratio close to 1.5 over the same period, that second fund has provided more reward for each unit of risk.

Using 0.7 as a starting point for portfolio discussions

You can also use a ratio like 0.7 as the starting point for a conversation about diversification. If you can add positions that smooth out the volatility, even if they are risky on their own, you might be able to lift the overall Sharpe ratio of the combined portfolio.

For example, you might have an equity portfolio with a Sharpe ratio below one. When you add another asset class that behaves differently, you could increase the combined portfolio's Sharpe ratio.

This can happen if the new mix delivers more excess return for each unit of volatility. In that case, even if the total risk level edges up, the risk-adjusted outcome can still improve.

Is the Sharpe ratio always accurate?

Short answer: no. The Sharpe ratio can sometimes be misleading. Here are three reasons why:

1. Market conditions can flatter the ratio

A fund that has a style or sector tilt that matches a favourable period can show a very strong Sharpe ratio for a few years. For example, a technology focused strategy during a tech boom can have very strong risk-adjusted performance over that window.

Once conditions change, the same approach can run into heavy losses, and the ratio can drop sharply.

2. Interest rate shifts are not captured

The risk-free rate in the calculation comes from the period you use. If interest rates move a lot after that period, the old Sharpe ratio does not show how the fund will behave in the new rate environment.

3. Standard deviation itself has weaknesses

Standard deviation treats upside and downside volatility as the same. Many investors are more concerned about losses than about gains that arrive faster than expected. This makes standard deviation an imperfect stand-in for what your clients truly feel as risk.

Because of these limits, it is helpful to use long-term data that covers different types of markets when you look at Sharpe ratios. A ratio that looks solid across various cycles is more convincing than a very high number over a short and unusual period.

You can also combine the ratio with other checks, such as drawdown analysis, sector exposures, and the manager's process. This helps you avoid relying on a single number when you recommend strategies to your clients.

Sharpe ratio and better conversations with your clients

The Sharpe ratio can help you move conversations with your clients away from return alone and toward return in relation to risk. In a world where your clients are surrounded by performance charts and rankings, this measure offers a way to link return with the experience of risk.

When you look beyond return alone and focus on return per unit of risk, you put your clients' comfort and long-term success at the centre of portfolio decisions. Used with care and combined with your own judgment, the Sharpe ratio can help you build portfolios that reflect your clients' goals while keeping volatility in perspective.

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