When you evaluate a mutual fund, the first criteria you may review could be investment performance, or return. In addition to return, the volatility of the fund, or how much and how quickly the value of the fund rises and falls, is a good indicator of the potential risk that you face with the investment. A Stanford University finance professor named William Sharpe created a way to easily compare mutual fund performance using these two indicators, called the Sharpe ratio.
Mutual funds are usually ranked based on their average returns over a certain time period. Fund performance will often be reported with one-year, three-year, five-year and even 10- and 20-year average returns on investment. Higher investment returns over longer periods of time usually indicate better fund performance, because the fund has been through more market fluctuations, while still delivering gains.
Volatility in mutual fund value is a performance indicator used as a measure of risk. A mutual fund value will fluctuate over time, and a stock market fund could lose a considerable amount of its value in a relatively short amount of time, sometimes within days or weeks. A less-volatile fund will not be as subject to the short-term larger gains and losses, keeping a more consistent value.
The Sharpe ratio is a number that compares the return of a mutual fund with the volatility. It is expressed as a ratio, with the top half, or numerator, consisting of the average return on investment over a specified time period less what could have been earned in a relatively risk-free investment, such as a three-month Treasury bill. The denominator, or bottom half of the ratio, is the standard deviation of the fund's performance over that time period, or how much and how frequently the fund performance strays from its average. Dividing the numerator by the denominator gives you the Sharpe ratio.
If mutual fund A has an average return over one year of 8 percent, and a standard deviation of 10 percent, you divide 8 by 10 to get the Sharpe ratio. In this case, the Sharpe ratio is 0.8. Mutual fund B has a one year return of 12 percent, but a standard deviation of 30 percent, the Sharpe ratio of fund B is 0.4.
General consensus is that a three-year or longer Sharpe ratio should be considered to be an accurate indicaors of the value a fund delivers for the risk that it poses. If a fund with a lower Sharpe ratio delivers a better three-year return on investment, you have a higher risk of losing money if you must sell fund shares during that time, because the fund volatility could result in you selling your shares at a loss. Also remember that the Sharpe ratio considers the past performance of a mutual fund, and the future results may be not follow the historical indicators.