How to Calculate the Sharpe Ratio

Imagine a long-term investor is evaluating potential exchange-traded fund (ETF) investments, and they've narrowed their selection down to two choices with similarly attractive returns, comparable expense ratios, and roughly the same market price. 

How do they decide which investment could potentially be the better choice? One method is to gauge the risk/reward trade-off of each investment using a fundamental analysis tool called the Sharpe ratio.

The Sharpe ratio is one of the most widely used calculations for measuring risk-adjusted returns. It's most frequently used to evaluate mutual funds, ETFs, and individual stocks, but it can be applied to any investment or portfolio.  

The Sharpe ratio, created by Nobel Laureate William F. Sharpe in 1966, helps investors evaluate an asset’s volatility (risk) relative to its returns so they can identify which investment might provide the best returns based on their risk tolerance. Essentially, it helps determine whether an asset's or portfolio's excess returns are the result of sound investment decisions or excessive risk-taking.

"The Sharpe ratio is a useful tool for investors who want to balance risk and return. It’s a relatively simple calculation anyone can use to compare two investments," said Nick Theodorakos, managing director, financial risk management at Charles Schwab.

While it's a solid addition to any investor's fundamental analysis toolbox, particularly those just starting out, it's far from a "silver bullet for a successful investment," Theodorakos explained. "Investors need to dig deeper into a portfolio to learn more about how the investments are being managed and whether leverage is being used," he added. This is important because leverage amplifies both gains and losses.

Investors can use either forecasted returns or historical data to calculate Sharpe ratios. However, it's important to understand that Sharpe ratios are inherently imperfect. Relying on historical results that may not reflect current conditions—or forecasts that are uncertain by nature—is a limitation that should always be considered.

There's no single, definitive way to compare how efficiently returns were generated relative to risk. Sharpe ratios are just one tool meant to help with that process.

Here's the Sharpe ratio formula:

Sharpe ratio = (Rp – Rf) ÷ Standard deviation

Key:

• Rp: Investment return (actual or forecast)
• Rf: Risk-free return (Investors typically choose a specific U.S. Treasury bill or note for this.)
• Standard deviation: A measure of risk based on an investment's volatility. A lower standard deviation may imply less risk and lead to a higher Sharpe ratio, while a higher standard deviation may imply more risk and lead to a lower Sharpe ratio, all else being equal.

The Sharpe ratio can help investors evaluate stocks, ETFs, or mutual funds, but investors need to select a lower-risk asset to use as a point of comparison in their calculation. Many investors favor using a comparison asset with a duration similar to their intended time horizon for the investment they're evaluating. For example, it might make sense to use a 10-year Treasury note when calculating Sharpe ratios for long-term holdings, while a 3-month Treasury bill could be used for a shorter-term investment.

"It's important for traders to recognize the changes in lower-risk yields over time," Theodorakos said. Changes in the yields of lower-risk comparison assets can have a substantial impact on Sharpe Ratios.

Sharpe ratio results can be either positive or negative and typically fall into these ranges.

Positive Sharpe ratio ranges:

• 0.0 and 0.99 is considered low risk/low reward
• 1.00 and 1.99 is considered good
• 2.0 and 2.99 is very good
• 3.0 and 3.99 is outstanding

Most investments fall into the 1.00–1.99 range, while readings above 2.0 could suggest the use of leverage to boost returns and, with it, risk. (Remember, leverage amplifies both gains and losses.) A reading of 2.0 or higher is a sign you may want to investigate the investment further.

• Negative Sharpe ratios below 0 indicate the investment is "suboptimal" because it has very high risk and very low reward.

A negative Sharpe ratio indicates the investment's performance or the fund manager's returns did not exceed the risk-free rate, meaning it potentially lost money during the time frame that's being analyzed. If a Sharpe ratio is in the red for a potential investment, consider evaluating the ratio of similar assets or funds.

If the asset under consideration (and its peers) all have negative Sharpe ratios, it could be due to a broad-based period of weakness in the associated sector. That might require further investigation of the sector overall.

Like all statistical measures, the Sharpe ratio has limitations:

• The Sharpe ratio alone does not reveal whether leverage was used to produce returns. Fund managers can use leverage to boost returns and potentially gain a higher Sharpe ratio. Investors will have to find leverage information by looking at a fund’s prospectus or fact sheet.
• The Sharpe ratio fails to account for the length of a fund's track record. For example, a fund with a relatively short track record, like six months, could annualize its returns for the purpose of calculating the Sharpe ratio over the course of a year. That would mean a significant portion of the returns are hypothetical and do not reflect a true return.
• The Sharpe ratio treats all market volatility the same. Upside volatility is what investors often seek, but the subsequent higher standard deviation measure in the denominator would result in a lower Sharpe ratio.

Even with its limitations, the Sharpe ratio can be a useful tool for investors seeking an investment with an attractive risk/reward profile. It can be used to quickly compare the relative risk/reward of different investments, allowing investors to find the highest return in line with their level of risk tolerance.

When used to measure a fund’s returns, this ratio can also measure the performance of the fund manager relative to a chosen risk-free rate. Investors can evaluate the Sharpe ratio of any investment on thinkorswim before entering a trade; it just requires a moment to set up.

For those interested in learning about other key portfolio return measures, check out the Information ratio or the Sortino ratio.