Use Sharpe Ratio To Buy Best Mutual Funds

Why it is necessary to use sharpe ratio to identify best mutual funds?

Because it is a more reliable way of identification.

People who do not know about sharpe ratio, how they select mutual funds?

Common practice is to see the historical returns to make the judgement.

The mutual fund which yielded best long term returns in the past, automatically becomes the first choice.

But looking only at the past returns of a mutual fund tells only half the story. What is the other half?

The other half is related to the risk taken by the mutual fund to generate the returns.

To judge the potential future returns more realistically, one must consider the inherent risk factor associated with a mutual fund.

How to include the analysis of risk-factor?

The best way is to use sharpe ratio to analyse funds before investing.

Generally speaking, there are several financial ratios that “stock” investors can use to judge stocks. But “mutual fund” investors does not have this liberty.

Hence Sharpe ratio has been developed to manage this deficiency.

The use of Sharpe ratio can be like a one-stop-shop for mutual fund investors.

I often refer to Historic returns, Expense ratio, Sharpe ratio etc to screen good mutual funds.

Why one must not look only at past returns?

All high-return generating mutual funds are not same. Why?

Suppose there are two mutual funds A & B.

Both funds generated returns in the past @15% per annum in last 5 years.

So as an investor, which fund is better for investing?

One must choose the fund with the highest risk-adjusted return.

What does it mean?

A mutual fund portfolio is composed of different assets like stock, bonds, cash etc.

The composition of portfolio builds-in the risk in the mutual funds.

Examples: Risk of following type of mutual funds:

  • Highest Risk: Only small-cap stocks in portfolio.
  • Very High Risk: Only mid-cap stocks in portfolio.
  • High Risk: Only large-cap stocks in portfolio.
  • Lower Risk: Stock, bonds, cash in portfolio.
  • Lowest Risk: Debt based mutual funds.
  • Neither low nor high Risk: Balanced mutual funds.

The portfolio which is most risky (like equity based funds), is most likely to generate highest returns.

But investing in such mutual funds, one gets also exposed to the possibility of high losses in “short term”.

Why we must worry about short term? Equity mutual funds must be held for long term right? Yes and No.

Yes because this theory is right. Equity funds must be held for long term (>3 years).

But there can be a situation (say due to an emergency), when the investor has to sell the holdings within 1 year.

In such a scenario, the potential risk of loss is very high is equity based mutual funds.

But use to Sharpe ratio helps us to identify those mutual funds which are less risky but can also generate decent returns.

The higher is the sharpe ratio the better. Why?

Because it means, the fund is capable of generating higher returns in proportion to the risk taken.

Sharpe Ratio and Standard Deviation…

This is is a general understanding in investment….

One must invest in such a mutual fund which offers high returns and less risk.

Sharpe ratio helps one to see-through a mutual fund and highlight its risk-return composition.

Lets understand this with an hypothetical example.

Suppose there are three mutual funds whose Average Returns in last 8 years has been 2.5% per annum.

Returns generated by the mutual funds in individual years has been as shown in below table:

MF 1MF 2MF 3
ReturnsReturnsReturns
Average2.5%2.5%2.5%
Year 12.50%1.0%-10.0%
Year 22.50%2.0%2.0%
Year 32.50%3.0%3.0%
Year 42.50%4.0%15.0%
Year 52.50%1.0%1.0%
Year 62.50%2.0%-7.0%
Year 72.50%3.0%12.0%
Year 82.50%4.0%4.0%
Std Dev0.0000.0120.084

Case 1: Mutual Fund 1

  • Standard deviation: 0.00.
  • Average return: 2.5%.

As standard deviation is zero, this mutual fund will certainly generate 2.5% in future.

Case 2: Mutual Fund 2

  • Standard deviation: 0.012.
  • Average return: 2.5%.

As standard deviation is 0.012 (higher than 0), this mutual fund is less likely to generate 2.5% in future.

Case 2: Mutual Fund 3

  • Standard deviation: 0.084.
  • Average return: 2.5%.

As standard deviation is 0.084 (higher than 0.012), this mutual fund is very less likely to generate 2.5% in future.

Formula to calculate Sharpe Ratio (SR)…

SR = (Rp – Rf) / Sd

Rp = Past return for a period.

Rf = Risk free return.

Sd = Standard deviation of mutual fund portfolio.

Example1: SBI Small Cap Fund (Equity Based, High Risk Fund).

  • Rp = 35% p.a. (in last 5 years).
  • Rf = 7.71% p.a. (Return of 10Y Government Bond).
  • Sd = 18.06 (high standard deviation means high risk).
  • SR = (Rp – Rf) / Sd = (35-7.71)/18.06 = 1.51

Example2: UTI Banking & PSU Debt Fund (Debt Based, Low Risk Fund).

  • Rp = 8.41% p.a. (in last 3 years).
  • Rf = 7.71% p.a. (Return of 10Y Government Bond).
  • Sd = 1. 61 (low standard deviation means low risk).
  • SR = (Rp – Rf) / Sd = (8.41-7.71)/1.61 = 0.43

Example3: Franklin India Low Duration Fund (Debt Based, Low Risk Fund).

  • Rp = 9.27% p.a. (in last 5 years).
  • Rf = 7.71% p.a. (Return of 10Y Government Bond).
  • Sd = 0.87 (low standard deviation means low risk).
  • SR = (Rp – Rf) / Sd = (9.27-7.71)/0.87 = 1.79

Example4: SBI Magnum Multi Cap Fund (Equity Based, High Risk Fund).

  • Rp = 20.87% p.a. (in last 5 years).
  • Rf = 7.71% p.a. (Return of 10Y Government Bond).
  • Sd = 14.27 (low standard deviation means low risk).
  • SR = (Rp – Rf) / Sd = (20.87-7.71)/14.27 = 0.99

Example5: Tata Equity PE Fund (Equity Based, High Risk Fund).

  • Rp = 24.97% p.a. (in last 5 years).
  • Rf = 7.71% p.a. (Return of 10Y Government Bond).
  • Sd = 16.26 (low standard deviation means low risk).
  • SR = (Rp – Rf) / Sd = (24.97-7.71)/16.26 = 1.06

Limitation of use of Sharpe Ratio

Sharpe Ratio in isolation may not be a very effective tool for investors.

Sharpe Ratio must always be used as a comparitive tool to arrive at a conclusion.

How to compare mutual funds using Sharpe Ratio?

Example: Suppose Sharpe Ratio of BSE Sensex is 1.8.

A mutual fund, whose Benchmark is BSE Sensex, has Sharpe ratio of 1.9.

As Sharpe Ratio of mutual fund is higher than its benchmark, it can be said to be performing well.

One can also use Sharpe Ratio to compare two similar mutual funds to conclude which one is better.

Apart from being a comparative tool, there is another limitation of Sharpe Ratio.

Debt based mutual funds has inherently low Standart Deviation (Sd).

The lower Sd often makes the Sharpe Ratio of Debt based funds at par with Equity based funds.

But does it mean that an equity investor can also buy debt based mutual fund? No.

One must always compare similar funds (Equity Vs Equity, Debt Vs. Debt etc) to arrive at a better conclusion.

Final words…

Looking only at past returns gives only part-picture of the funds performance.

The return must also be seen in comparison to the risk thrown at the investors by the mutual fund.

This can be done by looking at the funds Sharpe Ratio.

Equity based fund can generate more “excess returns” but also offers high risk (Sd).

[Note: Excess Returns: Rp-Rf]

SR = High Excess Return / High Sd

Debt based fund can generate lower “excess returns” but also offers low risk (Sd).

SR = Lower Excess Return / Low Sd

What does it mean?

It means, both equity and debt based funds has their own advantage and disadvantage.

Equity based funds are riskier, but this negativity is compensated by their ability to generate higher returns.

Hence their Sharpe Ratio (Excess Return divided by Sd) gets normalized.

Debt based funds generates less returns, but this negativity is compensated by their quality of being low risk.

Hence their Sharpe Ratio (Excess Return divided by Sd) gets normalized.

So does it mean that one can use Sharpe Ratio to compare debt and equity based funds? No.
Better is use Sharpe Ratio to compare similar funds.

Idea is to invest in that fund that offers highest Sharpe Ratio depending on ones investment goal.

If one’s goal is to earn annualised return of 12% CAGR in next 5 years, select a balanced fund with the highest Sharpe Ratio.

If the goal is to earn annualised return of 18% CAGR in next 10 years, select a flexible cap fund with the highest Sharpe Ratio.

For short term goals, one must select a debt fund with the highest Sharpe Ratio.

Mutual Funds Returns & their Sharpe Ratio.

(Updated: July’18)

SLLARGE CAP & MID CAP FUNDSSharpe RATIOReturns (3Y) %
1Mirae Asset Emerging Bluechip Direct-G0.7317.73
2Mirae Asset Emerging Bluechip Reg-G0.6716.82
3Canara Robeco Emerging Equities Direct-G0.5916.64
4Principal Emerging Bluechip Fund Direct- GrowthStart SIP0.5916.51
5Sundaram Large and Mid Cap Direct-G0.5813.48
6LIC MF Large & Mid Cap Direct-G0.5414.82
7Canara Robeco Emerging Equities Reg-G0.5315.25
8Principal Emerging Bluechip-G0.5315.29
9Sundaram Large and Mid Cap-G0.5212.67
10DSP BlackRock Equity Opportunities Direct Plan-GrowthStart SIP0.4513.55
11IDFC Core Equity Direct-G0.513.66
12Invesco India Growth Opportunities Direct-G0.513.75
13LIC MF Large & Mid Cap Reg-G0.4513.26
14Kotak Equity Opportunities Direct-G0.4212.32
BALANCED FUNDS
1ICICI Prudential Balanced Advantage Direct-GrowthStart SIP0.510.62
2Aditya Birla SL Balanced Advantage Direct-G0.4811.27
3Aditya Birla SL Asset Allocator MMFoF Direct-G0.479.84
4Aditya Birla SL Asset Allocator MMFoF-G0.479.81
5SBI Dynamic Asset Allocation Direct-G0.4510.31
6Franklin India Dynamic PE Ratio FoF Direct-G0.439.44
7Invesco India Dynamic Equity Direct-G0.4311.25
8Aditya Birla SL Balanced Advantage-G0.3910.31

Data Source: Economic Times.

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