Sharpe Ratio
This ratio measures the ratio of return earned in excess of the risk free rate (normally Treasury instruments) on a portfolio to the portfolio’s total risk
Portfolio risk is measured by the standard deviation in its returns over the measurement period. In other words it tells you how much better did you do for the risk assumed.

It is measured by: (Portfolio return – Risk free return)/Std deviation of portfolio

The Sharpe ratio is an appropriate measure of performance for an overall portfolio particularly when it is compared to another portfolio, or another index such as the Nifty, Mid cap index etc.

It tells us whether the excess return generated was due to smart investment or was due to a very high risk taken by the fund manager.

Treynor ratio
This ratio is similar to the above except it uses beta instead of standard deviation.
It’s also known as the Reward to Volatility Ratio.
It is the ratio of a fund’s average excess return to the fund’s beta.
It measures the returns earned in excess of those that could have been earned on a riskless investment per unit of market risk assumed.
It is measured by : (Avg Portfolio return – Avg risk free return)/beta of portfolio

Notes:
It would be useful to remember that any portfolio consists of two types of risks – systemic or market risks and non systemic risks.

Systemic or market risks represents the movement in portfolio due to movement in the market. This relation between the portfolio and the market movement is what is measured by beta. Hence Treynors measure measures the excess return per unit of systemic risk taken.This is the reason why it is generally said that Treynors’ measure is a good approach to evaluate well diversified portfolio.

Non systemic risks represents scrip specific risks.This is represented by the standard deviation of the portfolio. Hence sharpe measure uses this to measure the excess return generated per unit of risk of the portfolio itself. If you have a non diversified portfolio then it doesnt make any sense to compare it with the market indices because the movement of the scrip will rarely be influenced or will have no direct linkage to movement in indices.

What is “Alpha”

This is the difference between a fund’s actual return and those that could have been made on a benchmark portfolio with the same risk- i.e. beta.

So it is basically used to measure the relative performance of two funds having the same beta. i.e. comparing apples to apples. This gives a reasonable good measure of a fund manager’s performance and could be used for devising incentive strategies for the fund manager

Hope you found the above useful

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4 Responses to “”


  1. 1 kalika June 5, 2007 at 6:38 am

    Sir, how can the Sharpe ratio help us determine whether the excess return was on account of smart investment or due to a high risk being taken?…can you give a numerical for the same please…
    Does Standard Deviation measure the risk of the portfolio compared to itself? and beta measure the risk of the portfolio compared to market..??

    Also, what does “benchmark portfolio” refer to in explaining the term “alpha”

  2. 2 Srini June 6, 2007 at 12:45 pm

    kalika,
    can you please introduce yourself please ….
    thanks
    srini

  3. 3 kalika June 8, 2007 at 7:29 am

    i am member of your community for RS Classes, my name displayed here is different. my name is prachi.

  4. 4 Srini June 9, 2007 at 1:37 pm

    sharpe ratio measures the return ovr a risk free return to the std deviation of the portfolio. Meaning it calculates how much return you are generating per unit of risk being taken – so if the fund manager has generated the return by investing in a portfolio having a high degree of standard dviation then obviously he has not earned the excess return by smart investing but has chosen to take higher risk for generating that return – now as long as the risk pays off it is okay but but what happens if it does not – so it tells you the risk preferences of a fund manager.

    As far as std deviation and beta goes your understanding is quite perfect.

    benchmark portfolio refers to a representative portfolio – let us say your portfolio comprises of predominantly A group shares – then for you the benchmark portfolio could be either the indices or portfolio of any other well established fund having similar scrips

    hope this answers your query – if any doubt either blog me / email me or call me

    ciao!!!


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