A measure of risk-adjusted return. For relative return funds, the ‘risk-free rate’, represented by the return on a government bond, should first be deducted from the portfolio return, before dividing by the standard deviation of returns (a measure of volatility).
The resulting ratio can be explained as ‘return per unit of risk’.
Sharpe ratio = (Expected portfolio return – risk free rate) / portfolio standard deviation
For absolute return funds the Sharpe ratio calculation normally excludes the risk-free rate. There is an inverse relationship between risk and return. Investors are assumed to be risk-averse in general. That is, to incentivise them to take on more risk, they need to be compensated with higher returns. Thus potential returns need to rise with increased risk. Assets or portfolios with a low level of uncertainty or risk (such as government bonds) offer lower potential returns, whereas assets with high levels of uncertainty or risk are associated with higher potential returns. According to this trade-off, investment can only generate high returns if it is subject to a high probability of being lost.
Thus the Sharpe ratio depicts how much excess return is generated by a portfolio over the risk-free rate (minimal return), per unit of risk.
It will tell an investor whether his portfolio’s returns have been due to good investments or simply due to excess risk. The greater the Sharpe ratio, the greater the risk-adjusted performance. A high ratio indicates that the portfolio manager generated high returns without taking on too much additional risk.