Jargon Busting: Sharpe ratio

It was neatly designed to combine performance with risk and thus to address one of the core clichés of investment – you have to speculate to accumulate.

It helps test whether a fund manager’s speculating was adequately compensated by additional accumulating.

The higher the ratio, the better.

Let’s kick off with the basics. To work out the Sharpe ratio of an investment: take the return, subtract the risk-free rate and divide by the volatility of said investment’s returns.

The mystical risk-free rate is deserving of a column to itself, if not an entire PhD thesis, though for our purposes the bank rate or a suitable government bond yield will do.

In the current near-zero interest rate world, this part of the formula becomes immaterial; it will become more important if rates ever rise again.

For a real-world example, the table below gives the return and volatility for the Fundsmith Equity fund (a long-standing favourite of ours) and the MSCI World index in the past three years, according to data from FE Analytics.

We assume the risk-free rate is 1 per cent.

Comparing the two results, we can see that not only has the Fundsmith Equity fund outperformed the MSCI World index in absolute terms, but that it also has the higher, and therefore better, Sharpe ratio.

The Sharpe ratio can be used to appraise both retrospective and prospective investments.

As ever, there are elephant traps.

First, be careful when using backward-looking results: the Sharpe ratio will be at its highest at market tops and will signal gloom and doom at market bottoms, the very best time to be buying.

The Sharpe ratio of the FTSE 100 in mid-2007 was 1.6, whereas in mid-2009 it was –0.4.

Its usefulness is tempered by the bothersome, if unavoidable fact that the future may not look like the past.

It is deeply embedded in Hawksmoor’s investment culture that volatility does not equate to risk; it is one measure of it, but it is not the whole picture.

When we look at ‘risk’, we look at more than 15 different factors that may go wrong with an investment.

Volatility is just one player on the pitch.

Careless use of the Sharpe ratio can also cause you to forget the difference between a dog and its tail.

The return is the dog, the volatility tells us how fast the tail has been wagging in order to go walkies.

Getting rid of the bathwater of risk should not entail chucking out the baby of return.

Are we arguing that the Sharpe ratio is useless? Not exactly.

It helps in understanding a fund manager’s style in mixing performance and volatility.

In this risk-obsessed investment world, it can also help to mould an optimised portfolio asset allocation.

It is, though, only one spanner in your very large analytical toolbox; not very helpful on its own, but a useful component of a full service.

Jim Wood-Smith is head of research at Hawksmoor Investment Management