Two funds both return 12% in a year. One achieves it by taking large concentrated bets that gyrate wildly. The other achieves it through steady, diversified positions. Which is the better fund? The raw return is identical. The Sharpe ratio captures the difference.
The formula
The numerator is your excess return — what you earn above what you'd get from a risk-free asset (cash or short-term government bonds). The denominator is the volatility of those returns — how much they fluctuate. Divide one by the other to get return per unit of risk.
How to interpret the number
Limitations of the Sharpe ratio
Volatility isn't the only risk. Standard deviation treats upside and downside volatility equally. But investors only worry about downside volatility. A fund that makes large gains erratically will have a low Sharpe ratio, even if it never loses money badly. The Sortino ratio addresses this by only penalising downside deviation.
It can be gamed. Selling out-of-the-money options generates steady income (boosting the return) with low measured volatility — until a crash hits and the losses are catastrophic. A strategy can have an artificially high Sharpe ratio right up until it blows up. Bernie Madoff's fund reported a suspiciously high and consistent Sharpe ratio — a red flag in retrospect.
Time period matters. Sharpe ratios calculated over bull markets look very different from those spanning full cycles.
What this means for you
Use the Sharpe ratio to compare funds in the same asset class over the same time period — not across asset classes or different market regimes. When comparing two funds with similar mandates, the one with the higher Sharpe ratio is generating better returns per unit of risk. But always ask: what kind of risk is being measured, and what's hiding in the tail?