5.2 Sharpe Ratio and Risk-Adjusted Performance

From raw return to risk-adjusted return

Clients—and sometimes sales staff—rank UITFs by who returned the most last year. That ranking is incomplete. A fund that earned 18% with wild NAVPU swings may have delivered worse risk-adjusted results than a fund that earned 12% with moderate volatility. The Sharpe ratio is the classic exam metric that formalizes this idea.

Module 1 expects you to define Sharpe, compute simple examples, interpret “higher is better,” and contrast Sharpe with raw return and with beta/CAPM thinking.

The Sharpe ratio formula

Sharpe ratio = (Rp − rf) / σp

In words: how much excess return did you earn for each unit of total risk you took?

Units and practical notes

• If returns and rf are annualized percentages and SD is annualized, Sharpe is an annualized ratio (common presentation).
• If you mix monthly returns with an annual rf, the ratio is meaningless—consistent period is required.
• Sharpe is usually reported as a number (e.g., 0.80 or 1.25), not as a peso amount.
• Negative Sharpe means the portfolio earned less than rf (or a loss relative to rf) while still taking volatility—poor risk-adjusted outcome for that window.

Why divide by standard deviation?

Standard deviation (SD) measures total return variability—both systematic and unsystematic swings. For a single fund’s historical performance, total volatility is what the client felt in NAVPU. Sharpe therefore asks: was the ride worth the excess return?

Worked numerical examples

Assume the peso risk-free rate rf = 5% for the year (illustrative).

Fund A — Equity UITF

• Rp = 15%
• σp = 20%
• Excess = 15% − 5% = 10%
• Sharpe = 10% / 20% = 0.50

Fund B — Multi-asset / balanced UITF

• Rp = 11%
• σp = 10%
• Excess = 11% − 5% = 6%
• Sharpe = 6% / 10% = 0.60

Raw return winner: Fund A (15% > 11%).
Risk-adjusted winner: Fund B (Sharpe 0.60 > 0.50).

This is the exam’s favorite contrast: higher return ≠ better Sharpe.

Fund C — Money-market UITF

• Rp = 5.5%
• σp = 1%
• Excess = 0.5%
• Sharpe = 0.5% / 1% = 0.50

Fund C’s Sharpe matches Fund A’s in this toy example even though absolute return is much lower—because risk was tiny. Real money-market SDs and spreads over rf vary with the rate cycle; the teaching point is the ratio structure, not a claim that MM funds always match equity Sharpes.

Fund D — Volatile equity year

• Rp = 8%
• σp = 25%
• Excess = 3%
• Sharpe = 3% / 25% = 0.12

High volatility with modest excess return produces a weak Sharpe—common after a choppy equity market year.

Comparison table

Higher is better — with caveats

Interpretation rule: All else equal, the higher the Sharpe ratio, the better the historical risk-adjusted performance.

Caveats for UCP / real UITF conversations:

1. Past ≠ future. A high trailing Sharpe can collapse in the next bear market.
2. Apples to apples. Compare funds with similar mandates when possible (two equity funds) before crowning a “best fund in the bank.”
3. Different risk types. A bond fund’s SD is driven by rates and credit; an equity fund’s SD is driven by markets. Sharpe still ranks risk-adjusted return but does not say the risks feel the same to every client.
4. Leverage and outliers. Extreme strategies can distort SD and Sharpe; standard UITF long-only products are the exam baseline.
5. Not a suitability score. A high-Sharpe equity fund can still be unsuitable for a conservative retiree who cannot tolerate drawdowns.

Sharpe vs raw return (client script)

Weak pitch: “Equity Fund X returned 20%—best in class.”
Better pitch: “Equity Fund X returned 20%, but its volatility was also high. On a Sharpe (return above the risk-free rate per unit of volatility) basis, Balanced Fund Y actually delivered more reward per unit of risk last year. Which matters more depends on your risk profile and time horizon.”

That language supports CSA-aligned selling and reduces the temptation to chase last year’s raw winner into an unsuitable equity UITF.

Sharpe vs CAPM / beta (do not confuse the tools)

• CAPM is primarily a pricing / required-return model looking forward (or as a benchmark framework).
• Sharpe is primarily an ex-post performance statistic (can also be used with expected inputs, but exams stress historical interpretation).
• A fund can have β ≈ 1 (market-like CAPM expected return) yet a poor Sharpe if it underperformed with full market volatility.

Connecting to equity and balanced UITF risk

Philippine equity UITFs (≥80% equities) typically show higher SD and higher potential excess return over long horizons than money-market funds. Whether their Sharpe is attractive depends on how much extra return actually showed up versus the extra volatility.

Multi-asset / balanced UITFs often aim for a middle path: lower equity beta and lower SD than pure equity, with excess return that may produce competitive Sharpes in mixed markets. Interest-rate shocks can still hurt the bond sleeve (mark-to-market), so balanced-fund SD is not “equity risk only.”

Marketing takeaway for TOAP UCP ethics and sales modules later: risk-adjusted metrics support honest comparison; they do not replace RDS, plan rules, fees, liquidity, and suitability.

Limitations (exam-aware)

1. Assumes SD is the right risk measure — clients may care more about downside or loss of principal than two-way volatility.
2. Sensitive to the sample period — bull-market Sharpes look great; include a crisis year and ranks flip.
3. rf choice matters — wrong currency or wrong horizon for rf breaks the excess-return numerator.
4. Non-normal returns — large crashes make SD an incomplete risk story; still the standard UCP formula.
5. Cannot invent PDIC protection — no Sharpe number turns a UITF into a deposit.

Exam traps for this section

1. Forgetting to subtract rf — numerator is excess return, not raw Rp alone.
2. Putting SD in the numerator — SD is the denominator.
3. Thinking lower Sharpe is better — higher is better for risk-adjusted performance.
4. Equating highest return with highest Sharpe — opposite rankings are classic MCQ traps.
5. Using beta in the Sharpe formula — Sharpe uses standard deviation, not beta.

Mini decision tree

1. Need required return given market risk? → CAPM / beta.
2. Need historical reward per unit of total risk? → Sharpe.
3. Client only quotes last year’s %? → Reframe with excess return and volatility.
4. Negative excess return? → Sharpe is negative; risk was not compensated in that window.