Sharpe ratio

The Sharpe ratio puts return and risk into one number. In words: take the fund's return, subtract a risk-free rate, and divide by the fund's volatility, the standard deviation of its returns.

The risk-free rate stands for what money could earn with almost no risk, usually the yield on short-term government treasury bills.

For example, a fund returned 14% a year with a standard deviation of 14%, while treasury bills yielded 7%. The return above the risk-free rate is 7 points, and 7 divided by 14 gives a Sharpe ratio of 0.5.

How to read it:

• A higher Sharpe ratio means more return for each unit of volatility.
• A ratio below zero means the fund earned less than the risk-free rate.
• The figure depends heavily on the market conditions of the period, so it is most useful for comparing funds of the same category over the same years.

The Sharpe ratio treats a sharp rise the same as a sharp fall, because both add to volatility. The Sortino ratio counts only the falls. The information ratio measures return against a benchmark instead of a risk-free rate.