8/7/2019 Sharpe & Information Ratio - Presentation
1/13
Sharpe Ratio & Information Ratio
By Prof. Simply Simple
How do you select funds?
The most simple approach
would be peformance i.e.
returns.
But is it sufficient to track
only returns?
8/7/2019 Sharpe & Information Ratio - Presentation
2/13
8/7/2019 Sharpe & Information Ratio - Presentation
3/13
Here it is
The ratio Returns/Volatility expresses thismeasure. The measure will be high if returnsare high and volatility is low. A good fundwill have a higher ratio.
This ratio is the basis for Sharpe Ratio aswell as Information Ratio.
However it is interesting to understand the
diffference between them
Prof. Simply Simple will try to simplify theexplanation by drawing an analogy withcricket.
8/7/2019 Sharpe & Information Ratio - Presentation
4/13
Analogy
Imagine a cricket series has just got over and we areanalysing the performance of Sehwag, M S Dhoni (MSD)and Sreesanth
Lets assume the team played four one day internationals.
In these matches their scores were as follows:-
1. Sehwag (0, 0, 120, 160) Average 70 & StandardDeviation = 71.41
2. MSD - (60, 60, 70, 70) Average 65 & StandardDeviation = 10
3. Sreesanth (0, 0, 5, 20 ) Average 6.25 & StandardDeviation = 8.19
8/7/2019 Sharpe & Information Ratio - Presentation
5/13
What do we learn from these
scores? We realize that both Sehwag and MSD have had
a good run.
The average of Sehwag at 70 is higher thanDhonis 65. But the story does not end here.
Dhonis standard deviation is only 10 whileSehwags is 71.41.
Keeping the above measures in mind one is likelyto go with Dhoni for his performance + reliabilityas long as other parameters like strike rate etcare comparable.
8/7/2019 Sharpe & Information Ratio - Presentation
6/13
Sharpe Ratio decides as
follows Sehwag : 70 6.25 /71.41 = .9
Dhoni : 65 6.25 / 10 = 5.8
6.25 was the average of Sreesanth, the
worst batsman in the series.
The rationale over here is that 6.25 runs
were scored by the worst batsman. Any
thing above that is display of batsmanshi .
8/7/2019 Sharpe & Information Ratio - Presentation
7/13
But
A single measure is insufficient as themeasure of average would have madeSehwag a better bet and the measure
of standard deviation would have madeSreesanth better than Sehwag andDhoni.
Thus the Sharpe ratio takes bothmeasures of performance and reliabilityinto account to arrive at the quality ofthe batsmen and thereby supporting ourdecision of selecting Dhoni overSehwag.
8/7/2019 Sharpe & Information Ratio - Presentation
8/13
Mathematically
Sharpe ratio: (Rp- r) / Sp
Where
Rp Return of the fund or the portfolio
r The risk-free rate
Sp The volatility of the fund or the portfolio
Principally, higher the Sharpe ratio better is
the fund.
8/7/2019 Sharpe & Information Ratio - Presentation
9/13
So
One important feature that is observed whilecalculating Sharpe Ratio when applied to cricket isthat we compare the average runs of a batsman withthat of a bowler. In the world of finance the bowler is
the risk free investment option of Government bonds.
Hence we should compare the average of thebatsmen with the average of another batsman whocould be treated as a benchmark. That would throw
more light on the batting performance.
Similarly in funds we should compare theperformance with the benchmark funds performanceboth for returns as well as volatility.
This measure is called the Information Ratio
8/7/2019 Sharpe & Information Ratio - Presentation
10/13
Now
Lets assume Dravid is the benchmark
batsman for India in the series.
In our example Information Ratio wouldcompare the performance of the batsman
(Sehwag and Dhoni) with Dravid.
Lets say Dravid scored 80, 75, 85, 70 in thesame series. His standard deviation turns out
to 5.59. His average is 77.5. Both his
measures are better and hence he is chosen
as the benchmark.
8/7/2019 Sharpe & Information Ratio - Presentation
11/13
On comparison with Dravid
The information Ratio is calculated as
IR = Difference in averages of player
compared to benchmark / difference instandard deviation of player compared
with benchmark
So, IR of Dhoni = 0.34
8/7/2019 Sharpe & Information Ratio - Presentation
12/13
Thus
Information Ratio measures
the excess return of an
investment manager divided by
the amount of risk the managertakes relative to a benchmark.
The Sharpe Ratio on the otherhand compares the return of an
asset against the return of a risk-
free instrument such as Treasury
Bills.
8/7/2019 Sharpe & Information Ratio - Presentation
13/13
Hope you now know the
difference
In case of any query please email
Top Related