Sharpe ratio
The Sharpe ratio measures the excess return of an investment per unit of risk (volatility). It allows comparing ETFs of different risk levels on a common basis.
The Sharpe ratio, developed by Nobel Prize-winning economist William Sharpe, is the standard indicator for evaluating investment efficiency adjusted for risk taken. It answers a simple question: for each unit of risk accepted, how much excess return does the investor earn over a risk-free asset?
The formula
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Portfolio Volatility. If an ETF generates 9% annual return with 15% volatility and the risk-free rate is 3%, its Sharpe is: (9% − 3%) / 15% = 0.40.
Interpreting the Sharpe ratio
- Sharpe < 0: fund underperforms the risk-free rate (value-destroying)
- Sharpe 0 to 0.5: modest performance relative to risk taken
- Sharpe 0.5 to 1: good risk/return efficiency
- Sharpe > 1: excellent efficiency (hard to sustain over long periods)
Limitations
The Sharpe ratio assumes normally distributed returns, which is not the case in practice (markets exhibit fat tails). It also treats upside and downside volatility equally — only downside volatility is actually suffered by the investor. Alternatives: Sortino ratio (uses only downside volatility) and Calmar ratio (return / max drawdown).
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