Return for the risk taken
Sharpe, Treynor and alpha
A return on its own says almost nothing. The exam wants you to read it against two things: the risk it took and the benchmark it should have beaten. Start with the idea that a 14% return earned on a stomach-churning ride can be worse than a 12% return earned calmly, because the calmer fund is the one an investor actually stays in.
The tool that captures this is the Sharpe ratio: the return above the risk-free rate, divided by standard deviation. In symbols, Sharpe = (return − risk-free rate) ÷ standard deviation, and higher is better because it means more reward per unit of total risk. Work an example: a fund returning 14% with a standard deviation of 8, against a 6% risk-free rate, scores (14 − 6) ÷ 8 = 1.0; a rival with the same 14% but a standard deviation of 16 scores only 0.5. Its close cousin, the Treynor ratio, uses the same excess return but divides by beta instead, rewarding return per unit of market risk rather than total risk.
Two more measures complete the toolkit. Alpha is the return a fund earns above its benchmark (or its risk-adjusted expectation), so a positive alpha is the mark of a manager who genuinely added value. And tracking error, the standard deviation of the fund’s returns minus its index’s, tells you how tightly a passive fund hugs its index, where lower is better. One caution ties it together: these ratios are relative tools, compare them only between funds of the same kind, never a debt fund’s Sharpe against an equity fund’s. Read return, risk and benchmark together, and you are reading a fund the way a professional does.
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A high return earned with wild swings can be worse than a steadier, slightly lower one, so return must be judged against risk.
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The Sharpe ratio is the return above the risk-free rate divided by standard deviation; it rewards return per unit of total risk, and higher is better.
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The Treynor ratio is the return above the risk-free rate divided by beta; it rewards return per unit of market risk.
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Alpha is the return a fund earns above its benchmark (or its risk-adjusted expected return); positive alpha means the manager added value.
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The risk-free rate is the return on a near-safe asset, such as a short government security, and is the starting point for both ratios.
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Tracking error, the standard deviation of a fund's returns minus its index's returns, shows how closely an index fund follows its benchmark; lower is better.
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Compare Sharpe or Treynor only between funds of the same kind, the ratio is a relative tool, not an absolute grade.
A fund returns 14% with a standard deviation of 8, when the risk-free rate is 6%. Its Sharpe ratio is (14 − 6) ÷ 8 = 1.0. A rival returning the same 14% but with a standard deviation of 16 has a Sharpe of just 0.5, it delivered the same return on a far bumpier ride.
Practice
🔥 0 streakReal exam format. Answer by voice, tap, or press 1 to 4. No negative marking, so always attempt.
The Sharpe ratio is calculated as:
A fund returns 12%, the risk-free rate is 4%, and its standard deviation is 8. Its Sharpe ratio is:
The difference between the Sharpe and Treynor ratios is that:
A positive alpha means a fund:
For an index fund, a low tracking error means it:
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Education for the exam, not financial advice. Answers can be wrong, so confirm figures against the workbook.