A Razor Sharpe Tip

Published in Investing on 15 February 2010

Can a simple ratio help you find a good fund manager?

Why did you log on to the Fool today? If I had to work it out, I could use 'Occam's Razor'. This little rule says that "the simplest explanation is probably the correct one".

Sure, you might be logging on because you're an international spy using the site to pass coded messages to Moscow. That's possible, but the simplest explanation is that you're an intelligent private investor seeking first rate financial comment. Am I right?

Another simple rule is 'Hanlon's Razor': "Never attribute to malice that which can be explained by stupidity." Let's try this out with the collapse of Northern Rock: we could decide that the senior executives were involved in a sophisticated scam involving secret societies, Martians and devil worship; or we could conclude that they were really, really stupid. Which one do you prefer?

Comparing funds with the Sharpe Ratio

Simple rules aren't always right, but they're very handy for making quick decisions. And, when you're comparing investment funds, the Sharpe Ratio could be the only Razor you need.

Let's imagine you hold the 'Whizzbang UK Equity Fund'. You've had 13% return from it in the last year; the bank could have paid you 5% (dream on!); and the volatility (risk) of your fund has been 10% over the same period.

The return you could have had from the bank is called the 'Risk Free Rate'. If we subtract it from the fund's return we get 8%. This is called our 'Risk Premium': our extra reward for tolerating risk. Divide the Risk Premium by the Risk (8% divided by 10%) and we're left with 0.8. This is the Sharpe Ratio of the Whizzbang fund.

So what? One number doesn't tell us much on its own.

Now imagine another UK equity fund (let's call it 'Kaboom UK Growth') that also returned 13%, this time with a volatility of only 5%. Using the same simple calculation (13% minus 5%, this time divided by 5%) we get a Sharpe Ratio of 1.6. This tells us that the Kaboom fund manager earned his 13% 'more efficiently' than the chap at Whizzbang. 'Rational' investors should prefer to earn their 13% in the lower risk fund.

Another way to interpret the two numbers is that Whizzbang earned 0.8% return for every extra unit of risk in the fund. We assume here that the bank account is totally risk free with a volatility of zero. The Kaboom manager delivered a superior 'risk adjusted' performance even though both funds gave investors 13%: he earned 1.6% for every unit if risk he 'spent'.

Handle with Care

It's a useful trick, but a dangerous one. On the plus side, if you're searching the market for a fund manager worth paying for, the Sharpe Ratio can help you filter out the dross. Any UK equity manager with a ratio lower than the FTSE hasn't justified his existence. Most high-charging active fund managers fall into this category.

Even when you do find a fund with an impressive Sharpe, you need to be careful. Less liquid assets have a tendency to inflate the ratio.  

Commercial property funds, for example, don't have their assets priced every day like equity funds. Buildings aren't traded on liquid exchanges, so they only get valued by a surveyor every six months or so. This makes the 'volatility' of a commercial property fund lower than its 'true' risk. 

But the Sharpe Ratio is only aware of volatility risk, not liquidity risk. Quite a few private investors fell into this trap in the run up to the latest fall in property values. Embarrassingly, some IFAs made the same mistake and pushed commercial property funds as 'low risk, high reward'.

Sharpe is also a very poor measure for hedge funds, because its blind both to model risk (the risk that an apparently 'stable' investment technique can collapse entirely) and fraud risk (the risk that you've just given your life savings to Mr Madoff).

Madoff's Sharpe Ratio looked great, right up until the FBI arrived…

Sharpe is at its best when used intelligently. If you need to sort a large number of liquid, transparently priced assets quickly, and they are all doing roughly the same job, then it can be a handy filter.

But beware of any investment salesman who touts a 'high Sharpe ratio' as a reason to buy his product. Always look behind the scenes for the basics: why is this fund returning so much? Why is its volatility so low? Are these based on genuine economic activity or on financial jiggery pokery? If you can't understand, or even see, what's happening behind the curtains of a product then stay well away.

That's how to be a really Sharpe investor.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

BarrenFluffit 15 Feb 2010 , 10:52am

This is probably the clearest explanation I've seen of the Sharpe ratio and its practical limits. Excellent, great article.

MunroMan 15 Feb 2010 , 11:09am

The problem with the sharpe ratio is that it is comparing two different asset classes. A tracker fund would outperform cash in a bull market and vice versa in a bear market.

A much better measure is the information ratio. This measures how much better the fund has done against the index. By measuring the additional return relative to the extra risk a manager has taken you get a better estimate of whether his risk taking adds value.

RJJohnson2010 15 Feb 2010 , 11:17am

You're dead right, LordEssex. Sharpe assumes that your 'zero risk' position is a cash instrument; Info Ratio assumes that your 'zero risk' position is an index tracker, which can be viewed as a 'fund with no management'. In this sense, Info is a better way to discriminate for manager skill because it divides extra return against the index by tracking error volatility (how volatile around the index), and not by total volatility.

Another offshoot is the 'Treynor ratio', which takes divides by Beta instead of by standard deviation. This helps you decide who is making better use of market risk ('systematic' risk) and ignores the risks of individual shares.

hcidata 16 Feb 2010 , 8:57pm

How is the volatility (risk) of a fund calculated? Without that, the Sharpe Ratio cannot be calculated.

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