Mutual funds that are likely to offer healthy returns along with a lower level of risk are popular choices. But to identify funds that can offer such features, one should find out a way of measuring a fund’s risk-adjusted return. This is where the Sharpe ratio comes into play. Created by Nobel laureate William F. Sharpe, the Sharpe ratio is one of the popular ways of measuring funds’ performances on the basis of risk-adjusted return. A fund with a higher Sharpe ratio is believed to be more attractive than one with a lower ratio.

In this context, we have highlighted some favorably ranked mutual funds with a good Sharpe ratio, investing in which may prove profitable for those seeking healthy risk-adjusted returns.

What is Sharpe Ratio?

The Sharpe ratio of a mutual fund measures a fund’s average return relative to the level of volatility experienced by the same. It indicates the value that a fund delivers for the risk it poses. The numerator of the ratio consists of a fund’s mean return over a given time period subtracted by the return of a risk-free investment over the same period, say U.S. government Treasury bonds or bills. Meanwhile, its denominator comprises standard deviation of a fund’s return, which measures the level of fluctuation of returns, over the same time frame.

So, Sharpe Ratio = (Average Return - Risk Free Return)/Standard Deviation

This ratio indicates how much extra return one can derive from a portfolio by taking additional risk. For example, the three-year average return of a risk free investment is 2%. Now, if mutual fund A has a three-year average return of 10%, and a standard deviation of 8%, the Sharpe ratio of the fund will come at 1. For mutual fund B, which also has a three-year average return of 10%, but a standard deviation of 16%, the Sharpe ratio will be 0.5.

Then again, if a fund with lower Sharpe ratio has returned better over a time period than another fund with a comparatively higher ratio, it means that the risk of losing by investing in the former fund will be higher.

It is generally speculated that Sharpe ratio calculated over a three-year or longer period of time should be considered to judge the performance of a fund in terms of risk-adjusted return. We have already seen that the higher the Sharpe ratio, the more will be the fund’s attractiveness among risk-averse investors. Now, in terms of an ideal Sharpe ratio, most investors think mutual funds with a Sharpe ratio higher than 1 are good investment options.

Top-Ranked Funds with Good Sharpe Ratios

Against this background, we have highlighted four Zacks Mutual Fund Rank #1 (Strong Buy) funds having three-year Sharpe ratios more than 1. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on the likely future success of the fund.

Moreover, these funds have strong one, three- and five-year annualized returns. The minimum initial investment is within $5000. Also, these funds have a low expense ratio and carry no sales load.

T. Rowe Price Capital Appreciation (PRWCX - MF report) invests a minimum of half of its assets in stocks. The rest of its assets are expected to be invested in other securities including convertible securities, debt securities issued by both government and corporate bodies, and bank loans.

PRWCX has a Sharpe ratio of 1.44, higher than category average of 0.68. The fund has one, three- and five-year annualized returns of 5.4%, 10.7% and 10.8%, respectively. Annual expense ratio of 0.70% is significantly lower than the category average of 0.85%.

Fidelity Select Retailing (FSRPX - MF report) invests a large chunk of its assets in common stocks of firms involved in merchandising finished goods and services to consumers throughout the globe.

FSRPX has a Sharpe ratio of 1.33, higher than category average of 0.79. The fund has one, three- and five-year annualized returns of 10.6%, 17.5% and 17.6%, respectively. Annual expense ratio of 0.80% is significantly lower than the category average of 1.41%.

Invesco Diversified Dividend Y (LCEYX - MF report) primarily focuses on acquiring equity securities of companies that are expected to pay dividends. The fund invests in securities of undervalued companies.

LCEYX has a Sharpe ratio of 1.22, higher than category average of 0.73. The fund has one, three- and five-year annualized returns of 5.7%, 10.7% and 11.7%, respectively. Annual expense ratio of 0.57% is significantly lower than the category average of 1.10%.

Fidelity Select IT Services (FBSOX - MF report) invests the lion’s share of its assets in common stocks of both domestic and foreign companies that provide information technology services.

FBSOX has a Sharpe ratio of 1.20, higher than category average of 0.88. The fund has one, three- and five-year annualized returns of 3.9%, 17.1% and 15.8%, respectively. Annual expense ratio of 0.80% is significantly lower than the category average of 1.42%.