Mutual Fund Unlocked: Sharp Ratio, Treynor ratio, Jensens Alpha ratio
After understanding the R-squared, Beta and Standard Deviation, let's look into the ratios which will evaluate the risk adjusted performance of the mutual funds.
Sharpe Ratio
Sharpe ratio evaluates the performance of the fund with the risk taken by it. Therefore, the Sharpe ratio is also known as risk to variability ratio. It is nothing but the excess returns over the risk-free returns divided by the standard deviation.
The ratio is calculated by dividing the subtraction of portfolio returns and risk-free returns by standard deviation of the portfolio returns.
So, the formula for the Sharpe Ratio is
Sharpe Ratio= (Total Returns-Risk free rate)/Standard deviation of the fund
Greater the Sharpe ratio of the fund represents the higher risk adjusted performance. So the investors are advised to pick the investment with higher Sharpe ratio.
To rank the performance of the fund managers, Sharpe ratios, along with Treynor ratios and Jensen's alphas are often used.
Treynor ratio
Treynor ratio evaluates the additional returns generated by a fund over and above the risk-free returns. The ratio is quite similar to the sharp ratio but it considers the Beta as volatility measure.
The ratio is calculated by dividing the difference between portfolio returns and risk free rate by beta.
So, the formula for the Treynor Ratio
Treynor Ratio = Portfolio Return-Risk free rate/portfolio’s Beta
Higher Treynor ratio suggest the better performance of the fund. So investor are advised to pick the investment with trynor ratio
Jensen’s Alpha Ratio
The ratio is the performance ratio which evaluates the returns of the fund over its index. This helps investors examine the risk adjusted performance of the portfolio and determine risk reward profile of mutual fund. The ratio is calculated by subtracting funds beta from difference between funds return and risk-free return and multiplying the result by difference of index return and risk free return.
So, the formula is
Jensen’s Alpha= [ (Fund return-Risk free return)-(funds beta)*(Index return-risk free return) ]
A positive alpha represents the outperformance of the fund vice versa negative alpha represents the underperformance.
Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank the performance of portfolio or mutual fund managers.
To unlock more insights regarding mutual fund and its analysis, Stay Tuned to Mutual Funds Unlocked.
Mutual Fund Unlocked: Basics of Mutual Funds (Part I)
Mutual Fund Unlocked: Basics of Mutual Funds (Part II)
Mutual Fund Unlocked: NAV and Mutual Fund Costs
Mutual Fund Unlocked: Understanding the Ratios of Mutual Funds
Mutual Fund Unlocked: Information Ratio and Sortino Ratio
Mutual Fund Unlocked: R-squared, Beta and Standard Deviation