sharpe & information ratio - presentation

8/7/2019 Sharpe & Information Ratio - Presentation

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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?


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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.


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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


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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.


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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 .


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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.


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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.


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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


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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.


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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


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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.


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Hope you now know the

difference

In case of any query please email

to [email protected]

sharpe & information ratio - presentation

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