The Sharpe ratio has become the most widely used method for calculating the risk-adjusted return.
The Sharpe ratio was developed by Nobel laureate William F.
Sharpe and is used to help investors understand the return of an investment compared to its risk.
The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on.
Both State Street Global Research SSGRX and Morgan Stanley Inst. European Real Estate MSUAX has enjoyed heady three-year returns of 23.9% through August 2004.
But Morgan Stanley sports a Sharpe ratio of 1.09 versus State Street's 0.74, indicating that Morgan Stanley took on less risk to achieve the same return.
Sharpe Ratio = (Average fund returns − Riskfree Rate) / Standard Deviation of fund returns
It means that if the Sharpe ratio of a fund is 1.25 per annum, then the fund generates 1.25% extra return on every 1% of additional annual volatility.
A fund with a higher standard deviation should earn higher returns to keep its Sharpe ratio at higher levels. Conversely, a fund with a lower standard deviation can achieve a higher Sharpe ratio by earning moderate returns consistently.