A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been.
A variation of the Sharpe ratio is the Sortino Ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.
It is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
The Sharpe ratio is calculated as follows:
The ratio is subject to certain limitations. It does not serve as an absolute measure but relatively does well. It gives no meaningful information on its own, but it is useful to rank and compare MFs that are being evaluated for investment.