What is Sharpe Ratio?

Sharpe ratio, also referred to as the Sharpe measure or Sharpe index, is a measure used to gauge how well an investment is performing relative to its risk.

The Sharpe ratio is the average return a financial asset earned in excess of the risk-free rate adjusted for its risk. The risk-free rate is subtracted from the mean returns to give investors a better understanding of their investments by isolating the profit associated with risk-taking activities.

Generally, the higher the Sharpe ratio of an investment, the greater the risk-adjusted return. The Sharpe ratio can be used to evaluate a single stock or investment, or an entire investment portfo

Read also: The Real Estate Risk/Reward Spectrum

How to calculate Sharpe ratio

To calculate the Sharpe ratio of an investment portfolio, simply subtract the risk-free rate from the portfolio return, and divide the result by its standard deviation. The risk-free rate of return is the return on investment that investors can expect from an asset with zero risk. The yield for a U.S. Treasury bond, such as the one-year or two-year Treasury yield, can be used as the risk-free rate.

The standard deviation indicates how much the portfolio's return deviates from the average return and sheds light on the portfolio's volatility. Hence, the Sharpe ratio represents the additional returns that an investor receives per unit of increase in risk.

How to calculate Sharpe ratio from daily returns

Assuming a mutual fund has an average daily portfolio return of 0.25%, the risk-free rate is 0.15%, and a daily standard deviation of 2.00%. From this, we can calculate the daily Sharpe ratio to be 0.05. We can annualise this by multiplying the daily Sharpe ratio with the square root of 252 (which is the typical number of trading days per year in the U.S. market). Hence, the mutual fund’s Sharpe ratio is 0.794.

Average daily portfolio return = 0.25%

Risk-free rate = 0.15%

Daily standard deviation = 2.00%

Sharpe ratio = (0.25-0.15)% / 2.00% = 0.05 (daily)

Mutual Fund Sharpe Ratio = 0.05 x √252 = 0.794 (annualised)

Where,

Typical number of trading days annually in U.S. market = 252

Calculation of sharpe ratio from monthly returns

Assuming a mutual fund has an average monthly portfolio return of 1.25%, the risk-free rate is 0.25%, and a monthly standard deviation of 2.0%. Similarly, we can calculate the monthly Sharpe ratio to be 0.5. We can annualise this by multiplying the monthly Sharpe ratio with the square root of 12 (which is the number of months in a year). Hence, the mutual fund’s Sharpe ratio is 1.73.

Average monthly portfolio return = 1.25%

Risk-free rate = 0.25%

Monthly standard deviation = 2.00%

Sharpe ratio = (1.25 - 0.25)% / 2.00% = 0.50 (monthly)

Mutual fund Sharpe ratio = 0.5 x √12 = 1.73 (annualised)

Where,

Number of months in a year = 12

What you need to know about the Sharpe ratio

Sharpe ratio is the most widely adopted measure of risk-adjusted return. It can be used to evaluate a portfolio’s past performance (using its actual returns in the calculation formula), or evaluating a portfolio’s expected performance (using its expected returns in the calculation formula). Sharpe ratio is also useful for attributing a portfolio's excess returns to wise investment decisions or to an investor taking on too much risk.

The most important use of the Sharpe ratio however, is to identify whether adding a new asset to your existing portfolio will bring diversification benefits. Investors will seek to diversify their portfolios with assets having low to negative correlation in order to reduce the overall portfolio risk without sacrificing return. It assumes that risk is equal to volatility, hence diversification should consequently increase the Sharpe ratio compared to similar portfolios with a lower level of diversification.

What constitutes a good Sharpe ratio

The higher the Sharpe ratio, the greater a portfolio’s risk-adjusted return, and thus, the better the investment.

Sharpe ratios above 1.0 are generally considered “acceptable” by most investors, as the portfolio offers excess returns relative to its risk. Conversely, Sharpe ratios below 1.0 are considered “bad”, as returns do not justify the volatility. A ratio higher than 2.0 is “very good”, while a ratio of 3.0 or higher is considered “excellent”. Nevertheless, Sharpe ratios cannot be taken at face value, but should be used in comparing the relative risk-adjusted returns for different investment portfolios.

A negative Sharpe ratio may be due to the risk-free rate being greater than the portfolio’s return, or that the portfolio's return is simply expected to be negative.

Sharpe ratio and real estate

We have largely discussed the Sharpe ratio in the context of equity investing, but it is also highly relevant to real estate investing. Sharpe ratios are commonly found in real estate investment trusts (REITs) quarterly or annual earnings reports and in a crowdfunding real estate investment offering memorandum.

Read also: Real Estate Co-Investment – The New Alternative

For liquid, institutional-quality assets such as REITs and non-REIT stocks, the Sharpe ratio is a measure of excess returns per unit of risk. Particularly for REITs, in spite of being more homogeneous, nearly every segment of the US-REIT market has had at least one 12-month period outperforming the broad U.S. stock market by posting a higher Sharpe ratio. This can be attributed to the fact that property-type sectors differ markedly from one another even though they all respond to the real estate market cycle. Hence, the real estate asset class offers significant internal diversification opportunities as well as asset-class diversification relative to stocks, bonds, commodities, and other asset classes.

However, it is important to note that Sharpe ratios are typically not used for evaluating assets such as private real estate where there are significant risks other than volatility, such as illiquidity, or where volatility is not measured correctly. Moreover, the Sharpe ratio formula neglects two important features typically displayed by appraisal-based property returns: non-normality and autocorrelation. Both can lead to an underestimation of the true risk of direct property investment and thus an overestimation of the associated Sharpe performance.

About RealVantage

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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.