Popularized by the “father” of Modern Portfolio Theory, Bill Sharpe, the Sharpe Ratio is another excellent risk-adjusted metric. Whereas NCAlpha represents the "productivity" of a fund or portfolio, the Sharpe Ratio is the best measure for how much “bang for the buck” is provided for given level of risk versus a benchmark index. The Sharpe Ratio is the best risk-adjusted metric for volatility. It is calculated as:
(Issue's annualized Return - Low Risk Return's annualized Return) / (Issue's annualized Standard Deviation )
Where annualized Standard Deviation equals Monthly Standard Deviation * Sqrt(12).
The Sharpe Ratio demands that market returns come from something other than increasing volatility. Simple arithmetic will show that a 50% increase in returns created by a 50% increase in standard deviation is a loser. This ratio can be used as the basis of a ranking system that measures the fund manager’s performance more than it measures the fund’s performance.
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