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What Is The Sharpe Ratio?

Introduction

The Sharpe Ratio is a measure for calculating risk-adjusted return, and is the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. Instead of just looking at the total return of a particular stock or ETF, the Sharpe Ratio also looks at how volatile the stock or ETF has been. The concept is to try to get as high of a total return as possible with as little volatility as possible. So the higher the Sharpe ratio, the better.

The standard formula for the Sharpe Ratio is:

(Average return - Risk-free rate of return)/Standard deviation of average return

The idea behind subtracting the risk-free rate of return was to measure risk taking. An ETF engaging in 'zero risk' investment, such as the purchase of U.S. Treasury bills, for which the expected return is the risk-free rate, has a Sharpe ratio of exactly zero.

Sharpe Ratio Calculations Vary

Sharpe Ratio calculations tend to vary, for several reasons:

  • People calculate Sharpe Ratios using return data from different time periods (a 3 year Sharpe Ratio, a 5 year Sharpe Ratio)
  • People calculate Sharpe Ratios using different return periods (daily returns data, or monthly data, or yearly data)
  • People calculate Sharpe Ratios using different risk free return rates
  • People calculate Sharpe Ratios without using a risk free return rate
We believe the important point is that it does not matter which exact formula you use, as long as you consistently apply the same formula to all stocks, ETFs and portfolios you are comparing. Just be consistent. The point is to compare SMDV to SPY, not that SMDV should have a certain "target" Sharpe Ratio.

Our Calculations

We calculate our own Sharpe Ratios for all ETFs. Our calculations are done in the following manner:

  • We use monthly average returns to perform our calculations (not yearly or daily returns)
  • We do NOT use a risk free rate of return in our formula
  • We perform the Sharpe Ratio calculation for each ETF over the entire lifetime of the ETF (from inception until today).
  • Our calculations are automatically performed every night by our database, so all calculations are current (as of yesterday).
  • We also automatically calculate for each ETF what the Sharpe Ratio has been for SPY during the same time period, so that we can compare.
Keep in mind that for older ETFs, our calculations may generate a Sharpe Ratio that seems low. If you are used to looking at Sharpe Ratios calculated using 3 or 5 year return periods, those numbers are going to be pretty high, because we have been in the middle of a historic bull run. We are calculating Sharpe Ratios using returns from the lifetime of an ETF.

So, if you are looking at an older ETF, like IVE, the S&P 500 Value ETF, with an inception date of 05/22/2000, the Sharpe Ratio is 0.4638. IVE has been through two major market crashes (in 2002/2003 and 2008/2009), so it has a pretty low Sharpe Ratio during it's lifetime. But so too does SPY, an ETF that tracks the S&P 500 Index. SPY's Sharpe Ratio during the exact same time period is 0.4814.

A market crash obviously can have a significant impact on an ETF's Sharpe Ratio, because i) the average return of the ETF goes way down due to the market crash; and ii) the standard deviation of the return goes up due to the volatility. Because lifetime Sharpe ratios vary dramatically based on when the ETF was launched, it is important to only use the Sharpe Ratio to compare one ETF to the market (SPY) or another benchmark during the same time frame; absolute values are not important.

Benchmark Sharpe Ratios

We know that we just said there is no real "target" Sharpe Ratio. But it is only natural to think: "what is a good Sharpe Ratio"? If you want to get a feel for Sharpe Ratios over long time periods, here are some examples:

  • SPY has been around since 01/22/1993 and has a Sharpe Ratio since inception of 0.6873. SPY's total return since inception, including dividends, is 993%.
  • AGG, which tracks the Bloomberg Barclays Capital U.S. Aggregate Bond Index (i.e. fixed rate investment grade bonds), has been around since 09/22/2003 and has a Sharpe Ratio since inception of 0.7204. AGG's total return since inception, including dividends, is 60%.
  • EEM, an ETF which tracks emerging market stocks, has been around since 04/07/2003 and has a Sharpe Ratio since inception of 0.4843. EEM's total return since inception, including dividends, is 380%.

Note that the Sharpe Ratio probably tends to have a bias towards bonds. AGG's Sharpe Ratio compared to SPY's Sharpe Ratio is significantly higher, despite the enormous difference in total returns. The Sharpe Ratio is designed to reward "slow and steady" returns, which bonds have had in recent years. Yet few people would advocate that long-term investors should have an investment portfolio made up strictly of bonds.